March 18-22, 2024

Tactical Signal 9

Major averages naturally experienced heightened volatility given the recent inflation print but settled by the end of the week. With the accumulated strength, our technical indicators remain in a positive position (100%) for the time being.

Last week's unveiling of the CPI and PPI reports proved to be a seismic event, exceeding market forecasts and sending shockwaves through investor sentiment. The numbers defied expectations, setting a dramatic stage for the imminent FOMC meeting. With the CPI surging to 3.2% year-on-year from the previous month's 3.1%, essentials like rent, groceries, and transportation saw notable upticks, underscoring the tangible impact of inflation on everyday expenditures.

While the equity markets responded with relative calm, evidenced by the S&P 500's modest retreat of -0.09%, the bond market bore the brunt of the surprise inflation surge. Bond yields experienced a significant uptick, with the 10-year, 20-year, and 30-year Treasury rates widening by over +20 basis points compared to the previous week. This swift movement translated into a decline in bond returns by -1.23%, exacerbating the year-to-date bond performance, which now languishes at -1.72%.

The repercussions of inflationary pressures on the retail landscape were keenly felt as Dollar Tree announced plans to shutter 1,000 of its nationwide stores out of its 8,000-strong portfolio. Despite revenue growth, the company grappled with margin pressures from elevated costs. To navigate these challenges, Dollar Tree is undertaking strategic initiatives, including store closures and an adjustment in pricing strategy, raising the price range of select items from $1.50 to $7.

In the dynamic realm of technology and communication services, the landscape was a mixed bag. While stalwarts like Microsoft (+2.51%) and Google (+4.26%) notched gains, the semiconductor sector experienced a notable retreat, with key players like AMD (-7.87%), Intel (-3.09%) and Broadcom (-5.59%) witnessing declines. This downturn was compounded by reports indicating the Chinese government's push for EV manufacturers to source chips from local suppliers, diverging from Western imports.

Looking ahead, all eyes are firmly fixed on the forthcoming FOMC meeting scheduled for March 19th and 20th. Federal Reserve policymakers will convene to deliberate on monetary policy in the wake of the inflationary surge. While the prospect of an imminent rate cut appears remote, the overarching question looms large: What lies ahead for the remainder of the year, and how will the Fed navigate the increasingly complex economic landscape?

"We know that reducing policy restraint too soon or too much could result in a reversal of the progress we have seen on inflation and ultimately require even tighter policy to get inflation back to 2 percent. At the same time, reducing policy restraint too late or too little could unduly weaken economic activity and employment."

– Chair Powell's FOMC Press Conference, January 31, 2024.

How can Two Things be so Identical yet so Different?

Correlation Matrix

What's behind the "twins" cap-weighted S&P 500 versus the equal-weighted S&P 500? The difference highlights some of the concerns today around correlation and concentration not seen since the dot.com bubble.

The Magnificent 7 should be seen as a big flashing light rather than the superheroes of the markets. Why isn't anyone asking how it is that the market today has been literally defined by seven names? This answer comes to us when we try to understand what is today, a striking difference between two things: the S&P 500 equal-weighted and the S&P cap-weighted (commonly known as the S&P 500). In fact, cap-weighted indices are the norm, as almost every market, sector, and style index is cap-weighted.

In the S&P 500 Equal Weighted we can assume the maximum amount of broadest exposure across the “market” of stocks as each stock is represented equally.  While the S&P 500 cap weighted we can assume the same 500 names except that they are purchased by market cap weighting.  This is calculated using “shares outstanding x share price”, equaling market capitalization.

Who are the Mag 7 – Microsoft, Nvidia, Apple, Amazon, Meta, Google, Broadcom? See the chart above.

Our analysis shows that 100% of the Active Risk between the two "twin indices" is from this famous Mag 7. Translated to Tracking Error, or roughly the performance differential, is around 6%, which means that 68% of the time, in any one-year performance difference would be between the two could –6% to + 6% and 95% of the time between -12% and +12% difference. On rare occasions, the performance difference could be more than, + or - 18%, assuming normal distribution of stock returns.

Going deeper, half of this 6% risk is due to the Mag 7's company size or cap-weighting versus all other companies, and much of the other 3% is due to style, commonly defined as growth versus value.

This is where "correlation" comes into the analysis. The definition of correlation is "the mutual relationship or connection between things," or, here specifically, stocks. In the broadest sense for stock portfolios, a high correlation is the opposite of diversification, or what we call concentration.

To revisit what we looked at earlier, despite the 500 similar, if not identical, names, the cap-weighted portfolio construction methodology has created a more than measurable correlation between the largest companies in the Index. Quite directly, this is because cap-weighting is a "momentum" strategy that "owns" more of what does "well" in price return by giving it a bigger weight.

Yup, that's right. Own more of what goes up. Buy high, hope for higher, and then buy more!

Below, we have posted the actual extent of correlation in a chart for the Mag 7. The interpretation of this correlation matrix of the seven largest names, representing 23% of the S&P 500 Index, is that they are, by definition, highly moderate to strongly positively correlated!
Contrast that with any other random 7 names, and the bottom line shows that the correlation between random names is much lower, and that is the power and free benefit of diversification. Except that isn't the case anymore for the S&P Cap weighted, which in extreme corrections, those names will exhibit even higher correlation as risk assets move as one during times like the Great Financial Crisis and, more recently, the COVID-19 crisis.

Cap-weighted indexes are not necessarily bad as a methodology, except that, more often than not, companies that do well may have a connection or relationship that drives their shared success, given the factors that impact stock prices.

The similarities in technology, innovation, business models, clients, etc., have moved the Mag 7 to new heights.

Must I go on? Imagine your favorite food and you being forced to eat more, and the more you eat, the more you are required to eat, and so on.
Too much of a good thing can be too much of a bad thing. Could it be time to swap out one twin for the other?

Advisory services offered through Sowell Management, a Registered Investment Advisor. The views expressed represent the opinion of Sowell Management. The views are subject to change and are not intended as a forecast or guarantee of future results. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment. Stated information is derived from proprietary and non-proprietary sources that have not been independently verified for accuracy or completeness. While Sowell Management believes the information to be accurate and reliable, we do not claim or have responsibility for its completeness, accuracy, or reliability. Statements of future expectations, estimates, projections, and other forward-looking statements are based on available information and Sowell Management’s view as of the time of these statements. Accordingly, such statements are inherently speculative as they are based on assumptions that may involve known and unknown risks and uncertainties. Actual results, performance or events may differ materially from those expressed or implied in such statements. Investing in securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results.


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