What Lies Beneath

Fear is back in the Market, triggered again by the coronavirus spread. The media will certainly cite this explanation over the weekend. However, a sell-off was way, way overdue after an almost reckless rally the last few months. It was only a matter of time. The underlying health of the Market and Global Economy has not been great and is deteriorating. Stocks closed in the red for the week, something that has not occurred much since September. Another important factor: Interest rates have nosedived, and are back near all-time lows. The Bond Market has been telling a much different story than the Stock Market for a while. The 10-Year Treasury yield is below 1.5%; levels only reached during the sell-off last Summer as well as back in 2016. The 30-Year Treasury is below 2%, actually hitting an all-time low of 1.89% today. I will say it again, the 30-Year Treasury yield hit an all-time low today. The Bond Market is once again forcing the Federal Reserve’s hand, pricing in the need for the FED to cut interest rates again.

Chinese car sales plummeted 92% in the first 16 days of February, driven by the nation’s lockdown policy in response to the coronavirus. South Korea saw a spike in virus cases this week, with 100 reported in the last 24 hours making for a 204 total. This is the first major outbreak outside of China. South Korea’s economy is heavily weighted towards tech, consumer electronics and the global supply chain. The bullish narrative for stocks, which has revolved around central bank support, a 2020 earnings rebound, US economic acceleration, and expectations that coronavirus impact will prove temporary, is being tested big time right now. Stretched valuations and longer-term supply chain disruptions from the coronavirus on top of an already deteriorating economic backdrop around the globe is a real risk. Japan saw its Services PMI fall back into contraction and its lowest level since 2014. US Services PMI came in at 49, which is contraction mode. This is well below the 53 estimate. Total new orders shrunk for the first time in a decade. Importantly, this data measured a pre-virus period. What’s most concerning about this is that services in America are less exposed to China’s conditions and it’s the industry that fell most sharply. No matter how you slice it, this is not good.

Though fear is creeping back, investor sentiment is still fairly complacent. Making money has always masked underlying problems. Besides, buying the dip has worked this entire Bull Market. It’s going to work until it doesn’t, simply put. The Stock Market has been ignoring the warning signs from the Bond Market, the super-strong Dollar, as well as the price acceleration in Gold. The yield curve is inverted again. Stock leadership has been dominated by the Tech Titans, four of which have become $1 Trillion companies in this rally. Just five stocks —Apple, Amazon, Microsoft, Alphabet and Facebook— account for all of the recent S&P 500′s earnings growth. Think about that for a second 5 of the 500 or 1% of the index is responsible for all the earnings growth.

These five stocks account for 18% of the total S&P 500 value. Apple and Microsoft alone are now 10% of the index. Leadership has been razor-thin. After crunching the data from the 400+ S&P companies that have reported earnings so far this quarter, Goldman Sachs found that these five companies grew fourth-quarter earnings by 16% year-over-over. Overall, the S&P’s fourth-quarter earnings are up just over 1%. Without these five stocks, the index’s year-over-year earnings growth is flat. There has been a great deal of chasing the winners at play. This is activity reminiscent from two decades ago, before the Bubble burst. I couldn’t help but notice this headline this morning: Mom and Pop Are On Epic Stock Buying Spree Fueled by Free Trades. Activity like this tends to happen just before the party ends. We are studying it very closely and remain defensively positioned.

Tech is very vulnerable to a sell-off. Growth stocks, which have gone parabolic in recent months, are leading the declines. That’s new. But there are areas that have us intrigued. Gold has had a stealth move, punching through $1600 this week for the first time since 2013. We really like our large Gold holdings right now. With the Dow up just over 1% to start this early 2020, Gold is now up over 8%! We also like areas in Health Care and Financials and Communication Services. The two former sectors have been relative underperformers for years. We’ve also noticed Biotechs have come back to life. This growth sector has been in a downtrend since 2015, but is showing new signs of leadership. And Communication Services seem primed for this stage of where the modern-day economy is (think social media, streaming, online platforms, telecommunications). Small Caps fit this bill too. We are sharpening our pencils with focus in these areas.

What happens with the Bond Market → interest rates → yield curve → will very likely drive what happens in the Equity Markets over the next few quarters and potentially all year. For the Market to get the legs and ammunition required to stage another late-cycle advance to rival something like 1999, cyclical and value stocks have to participate. Systematic trading strategies have made them utterly dependent on the Bond Market. If we can see rates stall down here and then start to gravitate mildly higher, it can be enough for these key areas of the Market to gain leadership and help the Market see another strong advance. Without it, the Market remains dependent on the small conglomerate of growth stocks to keep the music playing.

Put simply, we need more breadth and broad-based stock participation in the Market. As of this week, 65% of stocks are underperforming the indexes. This high of a number of underperforming stocks has happened only one other time in the past 20 years, October of 2007. We went into such great detail above because we want to illustrate how important certain things are in the Market today, and we want to make sure this is NOT 2007.

Are the Olympics in Japan at risk? Just five months away, the International Olympic Committee stated that cancellation is not being considered. That’s what they’re saying publicly. Behind closed doors, it has to be. The Olympics have never been canceled or postponed due to anything other than war. To do so for a virus would be unprecedented. That said, there are already offers for London to host the 2020 Games. The United Kingdom has the facilities in place after hosting the 2012 Games. After Brexit, they would no doubt savor the opportunity for an economic burst to welcome back the world. Food for thought.

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

Mike & Mike

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