Black Swans & Market Rotations

For those of you who would prefer to listen:

Have you noticed an increase of black crows in your neighborhood over the years? Apparently, the crow population has spiked 15-fold in the Bay Area the last 2 decades. That, according to the Audubon Society. The black crow has become populous and common across the country. Conversely, there’s a black bird that is not so common: The black swan. They’re naturally found in Australia and Tasmania. For most of history, people didn’t know that black swans even existed.

A Latin phrase came to life around the 2nd century in Rome. It was in reference to seemingly rare occurrences. The phrase went like this: “Rara avis in terris nigroque simillima cygno,” which translates to “a bird as rare upon the earth as a black swan.” Back then and for many centuries forward, there was a widespread perception that all swans were white. Black swans either didn’t exist or were incredibly rare. There is no evidence that the Romans ever visited Australia or Tasmania. So, the phrase carried on.

A black swan event is defined as a consequential occurrence that is almost impossible to predict, yet after the fact seems to have been inevitable. Of course, humans are always excellent with hindsight bias. As they say, hindsight is 20/20. But the unpredictable nature of a black swan event is often the reason for its powerful effect.

Within a week, there have been 2 black swans and a case can be made for a 3rd. The assassination attempt is certainly one. I covered the horrific event earlier in the week. Let me know if you’d like to see it. A major Global Tech outage is another. I will cover this below. The 3rd is the potential withdrawal of a Presidential candidate, which could very well happen over the weekend. This has definitely been a stretch of extremely rare occurrences.

Our modern world is very interconnected. So interconnected that when one little piece of the system goes wrong, it can bring down entire industries. That’s what happened overnight. The connected world we live in has brought tremendous benefits, economically, socially and politically. It’s also introduced new problems and risks. That reality has brought pushback against the trend toward globalization. An increasing number of companies and countries are advocating for diversification, reshoring and protectionism. We certainly learned the hard way about our supply chain vulnerabilities in Covid.

Network outages were experienced around the globe, from Australia and Africa to Europe and the United States. It has impacted everything from airports and health providers to banks and stock exchanges. Many businesses that run Microsoft systems also experienced trouble. Millions of employees faced what’s called the “blue screen of death.” That’s what they saw when trying to log-in to their usual programs and systems.

The travel industry seems to be the worst affected. The airlines had both delays and cancellations. Global air traffic came to a near halt. European railway systems had major delays. People around the world were stuck. Sky News even went off the air for a bit. The London Stock Exchange’s information delivery system was impacted, preventing newswires and trade information from going out. JP Morgan wasn’t able to process some trades due to IT outages. Schwab’s trading electronic system was impacted, but we sprang into action early and were able to transact over the phone. Things improved over the course of the day. I must say, Dark & Early is more than words at our firm. It’s a mindset.

The immediate response to the global outage was confusion and an understandable panic. A cyber-attack is the biggest fear here. Fortunately, this wasn’t the case. The Cybersecurity company CrowdStrike quickly took responsibility for the outage, tracing the issue to what it called “a defect found in a single content update for Windows hosts.” It is believed to be exclusive to the Microsoft environment. The good news is it wasn’t a cyber-attack. This was self-inflicted by the cybersecurity company’s software update. The bad news is this type of thing can happen.

Serious question: If this can happen due to a simple software update, what happens if our adversaries successfully hack into systems and take over? That’s a rhetorical question I know, but one that needs answers and fast. Systems and services did come back online after hours of disruption, but this shines a light on the risks of a global shift towards digital, interconnected technologies. There are still far more questions than answers. One thing remains clear: We cannot blindly trust. We humans cannot become too dependent on technology.

Even before the assassination attempt and the global Tech outage, the Market had been in motion. US equities attracted $45 Billion this week, the fourth-largest inflow on record. Investor sentiment reached excessive bullish levels. The S&P hit a fresh, all-time high. Small caps landed $10 Billion of the flows, the second-largest inflow ever. The Russell 2K small cap index jumped 11% in just 5 days. That’s the largest such move for the index since April 2020, during the Covid crash up which followed the crash down. It retraced some of the gains heading into the weekend. The Tech-heavy NAS suffered. That’s new. Semiconductors had their worst day in 2 years. They’ve been leading the AI charge.

Volatile price action returned. There’s been a rotation out of the concentrated 2024 winners into the laggards. The 6 Tech Titans that have carried the Stock Market all year sold off. Small Caps and the Dow have been landing the flows out of Tech. It’s been a complete reversal from the first half of the year. Tuesday was the best day for the Dow in 2024. The NAS had its worst. Think about that for another second: one index had its best day of the year, and another had its worst on the same trading day. That’s how divergent the underlying stocks are inside each index at the moment. 

This rotating price action is corrective and it’s healthy. Call it mean-reversion. The 6-month performance spread between the S&P 500 and the S&P 500 Equal weight index was unusually high. The spread was over 10% heading into the week. It had only been higher at the Dot-com highs in March of 2000. Small Caps had the biggest 5-day outperformance on record compared to Large Caps as measured by the Russell 2K versus the S&P 500. This eclipsed the previous 5-day stretches, which occurred in March of 2020, the Covid lows, and October of 1987. Those of you that know, know what happened back then.

Rotations can be healthy, especially with the concentration of leadership and overstretched valuations. Rotations tend to be corrective and mean reverting. The opportunity had been ripe for quite some time. Corrections can come in both price and time. In other words, stocks can go down to digest big moves or they can go sideways for earnings to catch-up to excessive valuations. We’re seeing both right now. The sideways action of the S&P 500 is masking the fairly sharp declines in Tech stocks this week. The S&P 500 is back to where it started the month of July, which was then an all-time high.

Small Caps cannot absorb the rotation out of Tech alone. The Russell 2000 index, which consists of 2,000 small cap stocks, is worth a combined $3 Trillion. That’s the same value as Apple, Microsoft and Nvidia are alone. Picking up the slack were many of the Dow stocks like Coca-Cola, United Health Group and IBM. It’s times like this when these seemingly boring stocks are beautiful again.

There are many reasons for the rotational shift. It was inevitable. It was only a question of when. The simple fact is the Market was overbought after going skyward in July. The concentration in a few Tech stocks left most wondering, who’s left to buy? The slowing of inflation ignited excitement about the prospects for Fed rate cuts ahead. That benefits Financials and Industrials. It also presents opportunity for smaller companies to borrow cheaper and invest for growth. It could also be summed up as a Trump Trade. The prospects of his administration returning to the White House put a focus on other parts of the Market that could benefit from its stated policies, namely lower taxes, looser regulation and more tariffs on foreign goods.

A correction is definitely warranted for Tech, but we won’t dismiss the staying power of innovation and the subsequent revenue and earnings. That’s where the growth is. Everything has limits. Excitement tends to lead to euphoria. That’s where corrections tend to show up. Trees don’t grow to the sky.

You know what else hit an all-time high this week? Gold. The precious metal futures contract settled at an all-time high following Fed comments suggesting a rate cut could be coming. The Market is assigning a 97% probability of the first interest rate cut in September. The July Gold contract hit $2,462.40 per ounce on Tuesday. That was a fresh, new high. The July Silver hit $31.195/oz. That’s the highest in a decade. Momentum is positive behind both Gold and Silver, and their long-term uptrends appear to have resumed. The Street is jumping on board too. Citi had a report out calling for $3,000/oz for Gold, as financial flows show potential for significant expansion. They believe that the weakening labor market and the broader trend of disinflation are bullish for Gold and Silver. It’s finally paying to be diversified.

So, pay attention to those black birds out there. They tend to make noise and might have a signal or two to share. Low-tech signs still work. That’s critical when high-tech fails. The winds have changed. Volatility is back. Hang on for the ride. We’re in good shape and we’re prepared for whatever comes our way.

Have a nice weekend. We’ll be back, dark and early on Monday.

Mike

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