Raising The Caution Flag

Marc Zabicki:

Hello everyone. Welcome to this edition of LPL Research Market Signals podcast. My name is Marc Zabicki, Chief Investment Officer of LPL Financial. Joining me today is Kristian Kerr, who is our head of macro strategy. Kristian is responsible for running the day-to-day operations of our Strategic and Tactical Asset Allocation Committee, the body responsible for the macro-thought leadership of LPL Research. Kristian, first time on Market Signals podcast. Good to be with you.

Kristian Kerr:

Excited to be here, Marc.

Marc Zabicki:

Good, good, glad and we are recording this on Tuesday, February 20. And before we get into the meat and potatoes of what happened in the markets, just want to talk about, you know, the agenda before we set up what happened last week. And then we will get into what we think about markets as we move forward here. The agenda we are going to cover today we'll talk a little bit about the market, you know, recap and Kristian we'll get your thoughts on some of that. I know you've got some specific viewpoints on foreign equity markets, specifically in Japan, things to watch there. And then the long-talked about, or seemingly long-talked about in this forum and other forums across capital markets is the lack of breadth in market leadership.

Marc Zabicki:

And most of that breadth is really, or most of that market leadership is really centered in on the technology sector. We'll talk a little bit about that. And then a couple things that we're looking at as we sit here today this week, including the Fed meeting minutes which were indeed on tap this week. So if we look back last week, it's the first losing week since January 5, which was the first week of the new year. You know, U.S. equity markets closed down and, you know, global equity markets had a little bit of difficulty here and there, but U.S. equity markets were particularly weak based largely on some CPI and PPI numbers that were less than expected. You know, the CPI came in at 3.1% for January, and the market was expecting 2.9%. It felt like Kristian, that the market had started pricing in some level of affection. Would you agree with that? Or what's your assessment?

Kristian Kerr:

Yeah, I think that's fair. You know, particularly when it comes to inflation, I think there's you know, when you look at the beginning of the year, two things that consensus seems to be very clear about is that inflation is peaked and heading lower, and that, you know, we're likely to get either a soft landing or no landing. So I think when you set the bar that high it's fairly easy to get kind of prints like we got last week that kind of make the market maybe double take or think twice about that. So I think that's what we saw. I think a lot of times it's about the path to get there. So, you know, we might eventually get to the goals or the end scenario the market thinks we're going to, but it might not be a linear path. I think that's basically what would sum up kind of what happened last week.

Marc Zabicki:

Yeah. And it seemed like everything that had been working didn't work last week. Is that also fair?

Kristian Kerr:

Yeah, I mean, I think looking at this at kind of the performance numbers, you know, precisely that, the one that stands out to me is, you know, if you look at the S&P, you know, down 30 basis points on the week versus the Russell 2000, which was, you know, up 120 basis points. So I think that explains it pretty well. But, yeah, pretty much everything that worked since pretty much the first week of the year reversed last week a little bit you know, same goes for growth versus value international versus U.S. So, kind of that was the clear theme. I think it's early days really in terms of, you know, is this a major change in trend? You know, I don't think you can really know that from a week, but definitely something to keep an eye on just because the markets you know, are so crowded in these trades at the moment that that I think you need to kind of keep a weather eye on what's going on with respect to these rotations.

Marc Zabicki:

Yep. And same really for fixed income. And if we look, you know, kind of at commodities as well, I mean, you know, a little bit of weakness there across the broader commodity complex, but fixed income, I mean, you mentioned CPI, we talked about that at the open. You know, not quite meeting market expectations, which means people have to kind of dial back their Federal Reserve rate cut expectations more in line with what we think. I mean, we're expecting about four rate cuts perhaps in 2024. I think the market was pricing in more than that. So certainly the CPI number helped dial that back and that was reflected in the bond market. Anything catch your eye in fixed income?

Kristian Kerr:

Yeah, I mean, we basically priced out a full cut after all this and March expectations are effectively zero now. I do wonder if it means, you know, does this mean that the Fed is boxed in a little bit? And what I mean by that is it's a political year. So, you know, if the Fed doesn't want to be seen as political, you know, start coming September, can they really move if they want to? So it kind of, if we have a cut now coming in June at the earliest, it gives them three, maybe four months to do quite a few cuts. So I think that could be a potential thing to think about if the Fed really isn't motivated about not being seen as political. And in terms of kind of the performance last week too, I would also mention, you know, if you had told me that the inflation surprise and how it would've kind of played out the fact that commodities were so weak, you know, in general against that was quite interesting.

Kristian Kerr:

Because you would've thought that would've been the chance for them to shine a little bit, no pun intended. But I guess kind of the main commodity that matters for the indexes would be crude. And it did have a fairly solid week. So, perhaps just the composite of the index is what kind of reflects those numbers.

Marc Zabicki:

Yeah. And crude certainly helped the energy sector as well. So as we look ahead at this point, Kristian, you know, the market's obviously been on a near parabolic trend since October-ish. And we talked about at the open how things have gotten a little bit frothy, as we say. I mean, what's your assessment as we look at today's market conditions and maybe using the S&P 500 picture as a backdrop?

Kristian Kerr:

Yeah, I think frothy is a good term. We'll get into some charts that kind of show maybe some of the sentiments and positioning dynamics that are at play that warn maybe a correction, you know, could be in the offing. You know, these things are dangerous because, you know, we basically rallied over 20% in 70 trading days, so a little over two months. So these things can extend. So, you know, it's a dangerous game to try to play for a top, but I think kind of a correction would not be necessarily a bad thing here. But listen, you know, in the S&P it's tough to look at this chart and get to bearish, you know, we're holding gains above the all-time highs you know, well above these 50, 200-day moving averages.

Kristian Kerr:

So if anything, you know, I think Adam put this together, our chart, Adam Turnquist, our technician and you know, pointed out the RSI divergence was happening, which, you know, would tend to make you think that it could be a corrective you know, consolidation phase perhaps. So that's kind of where I'm at right now. You know, nothing negative at all in this chart, other than we've risen pretty far pretty fast. But, you know, I think the proof will be in the pudding. We do get a correction, you know, ideally want to see kind of support, you know, be found at those old highs, maybe down a little bit lower around those moving averages and kind of how we react there will really determine, you know, how aggressive this correction could be if we do indeed end up getting one.

Marc Zabicki:

Yeah. Yeah. And as we talk about, you know, kind of linear progressions of equities, I mean, you know, I think, which rarely happens in this market for an extended period of time on any asset price, but and true of CPI as well, where, you know, I think we went down in January CPI relative to where we've been in recent months, but it still wasn't good enough to satisfy the market. Which, you know, I think just based on, you know, CPI, I think it's well within our expectations, but, you know, the market, it started pricing in some irrational expectations in terms of the directional change in CPI. What do you think about the entire thing?

Kristian Kerr:

Yeah, I agree with that assessment. I touched upon it a little bit earlier, but you know, there are some lofty expectations priced in. If you look at some of the swap curves you know, August of 2024 the market's expecting a CPI print of less than 2%, right? So these lofty expectations, the more and more people get excited about them, there's a chance that you could get misses here and there. And quite frankly, you know, the geopolitical situation you know, the war in the Ukraine, the war in the Middle East, you know, these types of things tend to be a little bit kind of stoke the flames of inflation. So things that keep an eye on, I mean, I don't think this really necessarily changes our broader outlook, but just kind of be aware that the path to get there could, is not going to be this linear progression in terms of kind of going back to trend or sub-trend inflation. And I think that's the most important thing from a market standpoint to be thinking about.

Marc Zabicki:

Yep. And then looking, looking at the entire global equity complex, I mean, you know, we've been thinking about U.S. as the key place to be relative to other global equity markets. I think I still think that's a fair assessment, but I know you wanted to call your attention to what's going on or call this audience's attention to what's going on in Japan in terms of the favorable equity market prospects there. But, you know, we were hitting very interesting levels on the Nikkei, and I know this has caught your eye. What do you think?

Kristian Kerr:

Yeah, I mean, we peaked December 29, 1989. So it's been 34 years since this index has made new all-time highs. I think we somewhat take it for granted in the U.S. that equity markets, you know, always go up. And this is a pretty important chart, I think, for broader equities across the globe. And kind of just in, you know, what it signals potentially from a, you know, a long-term perspective for Japan. But, you know, kind of long-term, 30 year plus highs, you know, the same thing kind of happened in the U.S. indices after the 1929 crash. We didn't make new highs until the early fifties. And, you know, that was the start of a big secular trend. So perhaps that's going on. I think short term you know, whenever you get these 30 plus type year highs and you get to them, they're going to be a big psychological level for the market.

Kristian Kerr:

I would be very surprised if we just, you know, broke through it and went up another two, 3,000 points relatively easily. So, you know, there probably will be a bit of chop here, but we're clearly at a big turning point for the Japanese equity market from a psychological perspective, from a price action perspective. And I think it's worth monitoring. And we've been pretty positive on Japanese equities for a better part of a year now. And it's nice to see it kind of playing out, but I think you know, if we do kind of get a foothold above those all-time highs you know, this market could get really, really interesting. And you know, I think it plays into what we're seeing, you know, on the next chart with China just because intra-regionally you know, there, you know, you probably heard in the news, there were some hedge funds that were kind of, they were playing spread trades essentially.

Kristian Kerr:

So, you know, they were playing a bounce in China and a selloff in in Japan, which obviously hasn't really played out. So I do think with China, it's a big part of the emerging market indexes you know, literally got weighted at almost near the top. But, you know, we can see here, this chart goes back to 2021, basically 30% down from those highs. We've had about a 10% rally. You know, the Chinese policy makers are throwing just about everything they can at the market to try to bolster it. And it looks like they're finally starting to get a little bit of traction with that. You know, kind of one thing I just wanted to highlight here, and those white lines and the former lows, right?

Kristian Kerr:

So big, big important inflection points and typically, you know, you can gauge the character of a market pretty well by how it reacts at old lows, you know, if we got up there and kind of just failed again and turned back down, that would be a pretty negative signal you know, to most technicians. And the fact that we were able to, you know, from this rally post the Chinese New Year, be able to get, start to get a little bit of traction above there. That's a clear potential positive of at least an attempt at a near term bottom. You know, we also closed above the 50-day moving average. So you're starting to see some pretty decent technicals you know, in terms of how big or important of a potential shift this is.

Kristian Kerr:

I think it's a very early days you know, but the fact that we are starting to see a little bit of positive action here in the Chinese market, you know, bodes well potentially for kind of a, you know, maybe a more important short-term tactical move by Chinese equities. But I think we probably want to see us start getting you know, getting weekly closes, monthly closes, and potentially above some of these technical levels to start talking more aggressively about a real bottom in China.

Marc Zabicki:

Yeah. And I know, I mean, we've been underweight EM, and in part due to the fact of the weakness you see in China here and we've been, you know, it's been a good trade to be underweight, you know, broadly, EM, for the last 15 plus years, right? So the points you make are good. You know, are seeing what could be the early innings of a China bottom? We'll have to wait and see, you know, tactically, we think it's a little early to make that call as you stated. We're still underweight, you know, emerging markets, but these are the kind of things that we pay attention to. Going back to Japan for one second, I mean, you know obviously the market, you know, back near its all-time high is certainly newsworthy. What is the catalyst, what's been the driver in Japan this time around versus in decades past?

Kristian Kerr:

Yeah, that's a great question. I think in the near term, the catalyst was, and it didn't get much play, but it should have, is there was probably the most important speech given by the Bank of Japan on February 8. And they just highlighted very well that they're, that the way they approach policy is very different from the west, right? They have been facing, you know, a deflationary problem for the better part of three decades, and they're not going to move until they feel it's time. So I think coming into this year, if you approached Japan from a western mindset, you know, particularly what was going on with inflation, you know, I think Japan had inflation at 40 year highs or near 40 year highs to start the year. So the consensus thinking was, hey, they're going to most likely normalize policy.

Kristian Kerr:

And that speech kind of laid out that, you know, we view things different and we're not going until, you know, we are certain that we have beaten this deflation back, right? And they're not certain yet. And the fact that you know, Japan technically went into recession yesterday is another reason I think you're seeing kind of this leg up in the market here because, you know, they're expecting looser policy from Japanese authorities. I think that's kind of the near term catalyst. I think from a longer term catalyst, you know, they've done something structurally that have been very positive. So making kind of the equity markets there a little bit more western like which is starting to attract, I think, you know, global capital back to Japan and the fact that, you know, Japanese shares were basically on a price to book basis you know, kind of one of the more attractive G10 economies to say the least. You know, I think that definitely helped the story. So it's kind of a perfect storm of sorts where you've got policy plus structural changes that are all kind of leading to a potentially you know, bigger bull market in Japan.

Marc Zabicki:

Yeah, yeah. So, if we think about, you know, just the broader market in terms of focusing back on the U.S. let's talk about, you know, what you're looking at across, you know, the market here in this country. You know, clearly we're top heavy in terms of, you know, the key names driving the market in terms of market capitalization. What does this chart show you?

Kristian Kerr:

Yeah you know, again, this put together by our colleague Adam. But just really showing the concentration in the indexes that's really driving the returns. It's not necessarily a bad thing, but it's also unusual, right? So, you know, depending on how you slice and dice these things, you know, you can come up with a bunch of different ways to look at it. But I thought one, if you look at kind of the top 10 stocks and their influence on an index, you know, we're basically at the highest levels that we've seen that in since 1930s. And a couple takeaways is not necessarily a negative thing, because a lot of times what you can see is that the broader market will catch up. So you just need a natural rotation and kind of, you know, in S&P terms, the 490 starts to carry the load.

Kristian Kerr:

That's a way that this can play out. The more negative way this would play out is that doesn't happen, right? And then, and, you know, these top names start to lose a little bit of momentum, start to stumble a little bit, and then the rest of the market doesn't catch up. So it's more of a signal that this isn't usual. It probably can't last very long and very long being, you know, relative, you know, that could be quarters, but, you know, we've seen this for the better part of the year now. But just realize that the main point here is that this is an unusual situation and there is some risk here, you know, because of that, because it takes, you know, I think we'll talk about it a little bit later, but the Nvidia earnings, now it's tomorrow, it's basically a broader market risk at this point. So I think you start seeing those types of dynamics, you know, the indexes start to trade a little bit more like sector funds essentially, because they're so weighted like that. So just things to think about when you have this dynamic, again, not necessarily a bad thing, but just it's a little bit of a different game we've been playing when you have this type of concentration risk in the market.

Marc Zabicki:

Yeah. And speaking of concentration risk with this chart again by Adam Turnquist, our chief technical strategist, on market breadth. What's the takeaway here, Kristian?

Kristian Kerr:

Yeah, I mean, a lot of what I just said, right? I mean, it kind, I think this highlights it. Well, you know, I will say it's unusual for a market to be making all-time highs like the S&P and to be seeing 52-week lows kind of getting stronger, right? Which is for lack of a better word. So, that's an unusual situation, tends to suggest that you know, exactly what I was trying to highlight, that you have kind of just a few names leading the market higher, and you really kind of either need the broader market start catching up for the market to extend, or you could be due for a little bit of a correction. I think you, that's typically what you would see from you know, when you get kind of bad breadth.

Marc Zabicki:

Yeah. And I know, this chart is one of your favorites personally, so and what it speaks to probably is what you had just been saying, again, just a different way to look at it. What does this chart show you?

Kristian Kerr:

Yeah, so this is a mix of, you know, from some research partners we have at Vanda. And they you know, they look at positioning in the equity market in a variety of different segments, right? So, looking at you know, certain institutional flows, certain retail flows, and kind of having a way to dissect it. The interesting thing to take away from here is that, is that basically when we get to these extremes of positioning, so everyone buying the same things you know, this has happened, I believe seven times since the Global Financial Crisis, you know, 2009 and six of the seven, we've had pretty decent corrections from this positioning level. So again, not an end all be all holy grail that we're due a correction. But I think it is something that is a little bit of a warning sign that things have gotten a little bit too far too fast.

Kristian Kerr:

And the fact that kind of everyone is in on the same trades is a warning sign that perhaps you know, we might need to clear that out a little bit and also note, you know, we didn't include it, but you know, there's a host of these survey sentiment kind of data points and one was the consensus Inc. Which I believe just looks at newsletter writers and even some brokerage firm kind of opinions. And that got to the highest, most bullish levels in 20 years last week. So clearly everyone's kind of thinking the same thing that everyone looks rosy. And I think when you get to those types of types of points in the market, that's when you kind of have to think a little bit contrarian sometimes and say, you know, maybe, you know, maybe the market might need to pull back a little bit.

Kristian Kerr:

So, that's kind of what I see here, again. Very dangerous when you're in strong bull markets to try to be a top picker. So I'm not trying to advocate that at all, but just saying, you know, have a little bit of you know, a little bit of thought around, you know, well, what do I want to do if we do get a pullback, what levels would I want to, when I want to get re-involved in? Or, you know, does it make sense? Lightening some up here? Those are type of thinking or questions to be asking yourself when we're at these types of levels in terms of price positioning, sentiment in the market.

Marc Zabicki:

Yeah. And good. Well said. I mean, I talked a little bit about this in the Street View video, I mean, if, you know, if you're going to get out over your skis too far in the equity market, 2024 is certainly not, it's never good to do that anyway. But 2024 is not the time to do that, given all that's in front of us. And I mean, what we've talked about some tools for the toolbox here. Some of the things that we look at to kind of determine whether it's the right time to start thinking about a little bit of a contrarian view. I think we think that time is now, it doesn't mean we're not constructive on equities, it just means we're not expecting equities to go up in a straight line here. We thought we were going to have a fairly constructive year in 2024. It seems like we've gotten a lot of gains in a short amount of time. And that usually you know, brings you know, a pause, you know, down the road. In terms of Treasury yields, obviously, again, we've pulled back a little bit in terms of prices and yields have gone a little bit higher as a result of the changing Federal Reserve expectations. But what's the takeaway from this chart, Kristian?

Kristian Kerr:

Yeah, I mean, you know, we've run up quite a bit in terms of yield, I think probably more than most people thought. You know, we're overweight bonds. So, you know, don't really want to see us get too much above that 4.40 level in yields that might start suggesting that maybe something has changed in terms of the narrative. But I think, you know, extended a bit in terms of yields, but I think so far reacting at levels, you'd expect it and you'd want it to. And you know, I think if we do turn down here and we get kind of that bearish price action that you want to see up against, you know, old highs resistance you know, I think it sets itself up for a pretty dynamic trade in terms of bonds higher and yields down. So, you know, again, kind of did what it should have done given what we saw last week with the inflation numbers. But so far nothing really of significance in terms of technical damage. So, looking for us to, you know, ideally fail somewhere around here and then you know, probably get some sort of move back down, ideally down to those, the old lows from late last year.

Marc Zabicki:

Yeah. And our target for the 10-year Treasury yield remains unchanged. We started, it started a year, we posted this in actually early December, looking for the 10-year Treasury yield to end the 2024, around 3.75 to 4.25. And we're still thinking along those same lines. So correlation study here. Kristian, back to you on what the takeaway from this chart is.

Kristian Kerr:

Yeah, a couple things. I mean, I, you know, I would say we've started to see yields break or equity sectors break from yields, you know, most of 2022. That was a driver, for example. And basically since the middle of last year, we started to see certain sectors start to change. And then a couple things of note that really comes into really comes into fruition around earnings season, where you'll start to see, you know, particularly with things like tech you'll see that break from yields happen fairly aggressively and we're starting to see that again. Key thing here if I think in this chart is that energy hasn't, right? And we saw that last week where tech got hit on the move higher in yields and energy did well.

Kristian Kerr:

So it's kind of, energy's been the one area it's almost somewhat defensive now, and it's been having a tough time breaking away from that dynamic. But I think in terms of what we were talking about, broader picture in terms of the breadth picture things like that, this yield dynamic breaking down would be a good thing, I think for the broader market in terms of getting things to start trading a little bit different. And so I think there's some, just to be on the lookout for over the next you know, over the next few months is if we start getting these breakdown in correlations with the interest rate markets, that's probably a good thing for equities going forward if we can indeed get it.

Marc Zabicki:

Yeah. Okay. Week ahead, you know, clearly earnings, economic numbers as well and then the all-important FOMC meeting minutes tomorrow. You know, actually the global PMI numbers should be also of interest, but, you know in addition to Nvidia, and I think we may have a, we don't have a chart on Nvidia, I think what but we, you talked a little bit about Nvidia and the earnings there, Kristian, so it, you know, for your money, what's the thing that people should be paying attention to this week in global capital markets?

Kristian Kerr:

Yeah, I would actually, it's a great question. I would actually be a fade on the FOMC minutes. I don't think it's to be that significant, but I'll give you a substitute and that's going to be Chris Waller's speech on Thursday at 7:35 PM Eastern Time. Waller has become a much bigger and important voice at the Fed. And he's actually the one that kind of kicked off kind of the hopes about the rate cutting cycle starting earlier than was expected back in Q4 of last year. So he's an important one. I think the markets are a little bit confused right now, so he's giving a speech that's going to have a Q&A, it's an economic outlook. So I think that's a potential one to think about. It could be a market mover, it's going to happen when markets are closed, but I think that one's the one to be able look out for.

Kristian Kerr:

And I think, you know, the Nvidia numbers are going to be important for the market, you know, whether we like it or not, they're, you know, we spent a few minutes on concentration risk and Nvidia has been the primary driver of the nexus this year. So it's going to be significant. You know, I think the call afterwards is going to have potential broader market impact. So I think when we're looking out ahead at the week, I think, you know, those two things are what's on my radar. Obviously, I think the PMI to an extent can also be important. The minutes, I don't think it's important because it comes, you know, you're looking at backdated stuff, it's prior to a few key numbers and things like that. So it doesn't really give the market, I think, what it needs in terms of clarity with respect to Fed interest rate policy here. So that's why I think that Waller speech might be more important.

Marc Zabicki:

Okay, well said. And Kristian Kerr, LPL Financial's, Head of Macro Strategy, I thank you for joining me today. Welcome to this Market Signals forum. I'm Mark Zabicki, Chief Investment Officer. Thank you all for joining. Kristian and I. Be with us next week when Jeff Buchbinder will be back in this chair. Enjoy your week in capital markets.