According to Morningstar, US exchange traded funds saw a massive $40 billion weekly inflow for the week ending June 14, 2023. This was the sixth largest weekly amount on record and the flows, particularly into equity ETFs, appear to represent a significant shift in investor sentiment.

Meanwhile, according to the Wall Street Journal, bullish bets on artificial intelligence have been booming this month with more than 1.3 million call contracts on chip makers Nvidia Corp. (NVDA – $418.76), Intel Corp. (INTC – $34.10), and Advanced Micro Devices, Inc. (AMD – $110.39), changing hands on an average day. This burst of activity puts June on track for setting a record that would surpass the trading peak seen in November 2021. Keep in mind that November 2021 is quite memorable since the Nasdaq Composite index reached its all-time high of 16,057.44 on November 19, 2021.

And lastly, another example of extreme volume and extreme prices was seen in CBOE Global Markets data, where there has been record activity linked to S&P 500 index options, with one-day trading in calls surging and pushing up the prices of call options to extreme levels.

Couple this excitement with the $1.44 trillion sitting in retail money market funds (as of June 5), and one can see there is plenty of dry tinder on hand to move prices even higher. Market commentators on CNBC are suggesting it is “FOMO” – the fear of missing out – that is driving the surge in AI related stocks, some of which, like Nvidia have tripled in price in the last six months.

As I listen to analysts on CNBC talk about how artificial intelligence and ChatGPT will change technology as we know it, inspire trillions of dollars of investment and innovation, and disrupt companies that do not adapt, I cannot help but remember the excitement seen in similar times, like the Nifty Fifty era or the rally that led to the dot-com bubble of 2000. There is no doubt that there will be money invested and to be made in artificial intelligence; however, picking the right stocks at the right time will be crucial. Right now, it seems like patience and caution should be advised in view of the three-fold move seen in one of the best-positioned AI-related stocks – Nvidia.

Technicals

From a technical perspective, there are other signs of caution. The AAII sentiment survey has had three consecutive weeks of above average bullishness coupled with three weeks of below average bearishness. The last time this combination appeared, it lasted five weeks in October-November of 2021. This is another worrisome parallel to the November 2021 top in the Nasdaq Composite index. These parallels to the Nasdaq Composite are important since it is only a small number of technology stocks that are currently leading the June advance. News headlines are focusing on the 14% year-to-date gain in the S&P 500 index, but the Nasdaq Composite index has gained 29.5% to date, or more than double the S&P’s gain. Meanwhile, the Russell 2000 index has recorded a 5% year-to-date gain and the Dow Jones Industrial Average is up a mere 2.4%. It has not been a broad-based advance. However, if there is downside risk in the equity market today, we believe it is also concentrated in the Nasdaq stocks.

The 10-day new high and 10-day new low indicator is bullish averaging 193 new highs and 52 new lows. But our 25-day up/down volume oscillator remains neutral and reveals a lack of convincing volume in advancing stocks. More importantly, NYSE volume was below the 10-day average for many days during the early June advance and the highest volume days in the last four weeks have taken place on May 31, 2023 when the DJIA lost 134 points, June 16 when the DJIA lost 109 points and on June 23, when the DJIA lost 219 points. These high volume down days suggest distribution, not accumulation, of equities. See page 12 and 13.

Last week’s decline in the indices is barely perceptible in the charts of the SPX and IXIC, just like the June rally is not significant in the charts of the DJIA and RUT. The unweighted S&P 500 ETF is similar to the RUT and has been rangebound. See page 11. The Russelll 2000 index remains our main focus and it suggests the market remains in a long-term trading range.

Valuation

If we deconstruct the drivers of the 2023 equity market, we find that gains are due to a combination of earnings expectations and multiple expansion. A chart of IBES Refinitiv and S&P Dow Jones quarterly earnings expectations for the next seven quarters shows that analysts are anticipating solid straight-line EPS growth through to the end of 2024. See page 8. Unfortunately, PE multiples are currently above the standard deviation range, a sign that stocks are not cheap. And ironically, the 12-month forward PE is higher than the 12-month trailing PE, due to the deceleration in earnings growth seen in the first quarter. That is rare, and it is a pattern that often appears before an earnings decline. Moreover, if we look at the historic relationship between nominal GDP and S&P operating earnings, we find that earnings are, and have been, well above trend since early 2021. These outsized earnings gains could be due to margin improvements or post-pandemic stimulus; however, history suggests that this excess-earnings trend is not sustainable over time. See page 9. In sum, EPS expectations are robust, PE multiples are high, and EPS are rising faster than the underlying economy. It is a treacherous combination.

Economy

May’s inflation data produced good news, particularly headline CPI which fell 0.9% to 4% YOY. Yet, prices for food, housing, recreation, and services continue to rise faster than headline CPI. What helped May’s inflation data was a decline of nearly 12% year-over-year in energy prices. Still, inflation trends are generally decelerating, even for owners’ equivalent rent. See page 3. Although most of the deceleration in inflation is due to the dramatic decline in the price of crude oil — which was the initial catalyst for surging inflation in 2021 — the residual problem is now service sector inflation. Service inflation is driven by wage inflation, not energy prices. Unfortunately, the tightness in the labor market may make it difficult to reverse this trend quickly. See page 4.

Retail sales rose 1.6% YOY in May led by restaurants, drug stores, and nonstore retailers. But based on 1982 dollars, total retail and food services sales fell 2.4% YOY, the sixth negative month in the last seven. Typically, when real retail sales have been negative for more than a month or two it has been a sign of an economic recession. It might be different this time, but other data also suggest a recession is on the horizon.

The Conference Board leading economic indicators index declined again in May marking 14 straight months of declines. This is the first time the LEI has been down for 12 consecutive months or more without an economic recession being in place. In addition, the inversion in the yield curve is the greatest of any seen in over 42 years, and it too has historically predicted both economic recessions and bear markets. In our view, the missing ingredient for an all-out recession is negative year-over-year growth in jobs. A healthy post-pandemic labor market is sustaining the US economy. See page 5.

Consumer confidence surprised favorably in June. The Conference Board Consumer Confidence Index gained from an upwardly revised 102.5 in May to 109.7 in June — its highest level since January 2022. The outlook for business and the labor market improved in June. The University of Michigan survey was up from its May low, but it remains below January’s level and is stuck at a recessionary level. Similarly, May housing data included tentative signs that the decline in the residential housing sector could be bottoming. Nonetheless, assuming interest rates will move higher in the months ahead, it could be a tentative bottoming process, at best. We remain cautious.

Gail Dudack

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PLEASE NOTE: Unless otherwise stated, the firm and any affiliated person or entity 1) either does not own any, or owns less than 1%, of the outstanding shares of any public company mentioned, 2) does not receive, and has not within the past 12 months received, investment banking compensation or other compensation from any public company mentioned, and 3) does not expect within the next three months to receive investment banking compensation or other compensation from any public company mentioned. The firm does not currently make markets in any public securities.

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