iCapital Market Pulse: Investors With Too Much Cash (Relative to Strategic Allocations) May Want to Gradually Buy This Dip

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For most of the first quarter, investors were concerned about the low level of volatility, as measured by the VIX Index. However, equities corrected given sticky inflation, repricing of Fed policy expectations, and a sharp move higher in yields, shifting the focus from a soft-landing to a no-landing view – similar to what we saw in Q3 2023. Now, with equity markets roughly 5% off their highs, the question becomes – is this the start of a worse correction or should this dip be bought?
 
We believe investors with too much cash (relative to strategic allocations) should gradually buy this dip. We are encouraged by the technical setup that is now much cleaner for investors versus in the start of April. The upside move in yields is likely exhausted in the near term as: 1) yields more accurately reflect the growth and policy environment; 2) there is potential for this week’s core Personal Consumption Expenditures (PCE) to ease inflation concerns; and 3) the earnings season is beating estimates.  We go into further detail on these developments below.
 

Market technicals are cleaner now vs. the start of the month, although some concerns remain

Given the strong market performance to start the year, equity markets were clearly in overbought territory, as the 14-day relative strength index (RSI) was above 70 in January and February.  However, the RSI is now approaching oversold levels, or a reading less than 30, which is its lowest reading since the market low in October 2023. In addition, we also see an increasing share of stocks have reached oversold levels. Indeed, 12% of the S&P 500 now have an RSI that is less than 30, again the highest reading since the market low last fall.¹

The percentage of S&P 500 Index members making new one-month lows would also suggest that markets are now oversold. After the stronger than expected retails sales reading, we saw new one-month lows spike to 56%, which was the highest reading since the regional bank crisis last spring.² This is a critical level as historically, we get readings of 50-60% when equity markets start to trough.³

In addition to the cleaning up of market technicals, sentiment has also corrected. Indeed, when we look at the American Association of Individual Investors (AAII), bearish sentiment has ticked-up to the highest levels since November of last year.⁴ The spread between bullish and bearish sentiment has declined from 95th percentile over the last 10 years, and now stands at 4.30.⁵ If we see this spread fall below 0, which would indicate that there are more bears than bulls, it would be a sign that sentiment is getting overly pessimistic.

However, positioning for Commodity Trading Advisors (CTAs) and hedge funds still appears long with potentially more derisking to go, which could deepen the pullback. CTAs are near max long and therefore we could see continued deleveraging if the S&P 500 breaks below 4,900. This is why we would be buying this pullback gradually – while we await buybacks to come back and households to step in, counteracting any systematic selling pressure.

Upside move in yields more likely reflects the adjusted growth and policy environment

After the sharp move seen in yields, a consolidation or a peak in yields would be a positive for equities, similar to what we saw in the fall of 2023. After the March Consumer Price Index (CPI) print, we witnessed the U.S. 10 Year Treasury increase by 18bps, which is in the 99th percentile of all daily moves going back to 1990.⁶ Historically, after we see a move of this magnitude, rates tend to consolidate or even start to drift lower. Indeed, in the six months after this large of a move, the U.S. 10 Year Treasury yield typically declines by an average of 6bps. While not a large move by historical standards, this suggests that the sharp move higher in Treasuries may be behind us.

We also believe that yields could start to consolidate as the U.S. 10 Year Treasury is currently trading above fair value assumptions including rate cut, inflation, and growth expectations.

While markets were discounting almost seven rate cuts at the start of the year, now they are only expecting one and a half cuts for 2024 – more aligned with Fed forecasts. Indeed, if one Fed official were to raise their 2024 policy rate forecast, this would bring the median forecast to two rate cuts for this year. Even looking at growth forecasts for 2024, we have seen estimates get revised higher throughout the year. Starting the year, economists were forecasting GDP growth of 1.3% for 2024.⁷ Over the course of the year, these forecasts have risen by 1.1 percentage points (ppt) and now GDP is expected to grow by 2.4% in 2024.⁸

It appears that treasury yields are now two standard deviations higher than where these variables would suggest and this divergence from fair value is the greatest since October 2023, which was when yields peaked.⁹

This week’s core PCE could alleviate some inflation concerns

We think this week’s core PCE reading will be important in determining the Fed’s rate path for the remainder of the year, and if yields can ultimately stabilize around current levels. While there is much focus on CPI (it is released earlier in the month and has a 70% overlap with PCE), there is a wide divergence in the remaining 30% of the baskets that differ. These divergences have caused a wedge to open up between PCE and CPI, which could lead investors to place a greater importance on PCE readings going forward.
The wedge is particularly notable within the healthcare and auto insurance categories. While these two components were very strong in the CPI release, they were softer in Producer Price Index (PPI), which came out later in the week. Given PCE derives its health care and auto insurance measures from PPI, there is a chance that PCE data could alleviate some of the inflation fears that were stoked by the strong CPI reading.

Another reason why we believe markets will focus on PCE is because of the difference in the weighting of shelter/housing between the two inflation baskets. Indeed, shelter makes up almost 33% of the CPI basket, while only making up 16% of the PCE basket.¹⁰ While rents have remained sticky, rents appear to be trending in the right direction based off other rental measures and real-time data Last week, the U.S. Bureau of Labor Statistics (BLS) New Tenant Rent Index rose by 0.42% over the last four quarters, the slowest rate of growth since 2010.¹¹ This highlights that rental inflation should come down in the second half of the year, as the BLS uses the same survey data in the new tenants rent index for the OER/Shelter categories of CPI.¹²

Currently, core PCE is expected to come in at 0.3% MoM, which is slightly softer than the 0.4% MoM increase we saw for CPI. As a result, the yearly rate for core PCE is expected to fall to 2.7% – a full percentage point lower than CPI.¹³

Given the more favorable trend of core services ex-shelter for PCE, we think the consensus estimates for core PCE to reach 2.5% YoY by year-end are achievable. While Fed Chair Powell in a recent speech acknowledged that “recent data showed a lack of further progress on inflation,” we believe core PCE getting to 2.5% could give the Fed enough confidence to cut rates later this year.

What if the Fed doesn’t cut rates at all this year? Earnings should still support equity markets.

Earnings should at least partially offset the compression in valuation due to higher rates. Despite the negative equity market reaction to the start of the reporting season, earnings have gotten off to a strong start. While only 14% of companies have reported earnings as of April 19th, roughly 74% of S&P 500 companies have reported earnings that came in better than expectations, which is in-line with its 10-year average.¹⁴ While earnings have only grown by 0.5% on a YoY basis, earnings have positively surprised by 7.8% so far this quarter – slightly higher than its 6.7% 10-year average.¹⁵

We believe the earnings picture should brighten later this year, as earnings growth is expected to broaden out. Indeed, earnings growth estimates for the 495 names in the S&P 500 are expected to catch-up to YoY earnings growth for the “Magnificent 5” later this year.¹⁶ We think broader earnings growth should be a positive for markets. Indeed, in our 2024 Outlook we discussed the market scenario without the rate cuts. We reiterated that even without rate cuts, we expect equity returns to be positive, but less so than before. A 19-20x multiple and $276 of 2025 EPS estimates still justifies the SPX at 5,200-5,500. This means that after the recent correction, the upside to 5,400-5,500 for the SPX by year-end has now improved to 8%.

We believe investors with too much cash can take advantage of this dip

Given the overall constructive fundamental view, appropriate repricing in rates, and a better technical backdrop than appeared at the start of the month, once we get through the peak of the corporate buyback blackout window, stocks should be supported – even if the Fed doesn’t cut rates.

But if the Fed stays on hold, aren’t money market rates still attractive? We note that as attractive as a 5.5% money market yield might seem on the surface, it is worth much less than that after accounting for taxes. Meanwhile, given the recent pullback, the upside potential for stocks has improved. Thus, we believe investors that are under allocated and under positioned relative to their strategic asset allocations should take advantage of this dip and add to their equity exposures.