The SPX Sector Report: January 18, 2024
The SPX Sector Report: January 18, 2024
Where we could be wrong in our emphasis on Tech.
Discussion
We have a jammed schedule this week and wanted to get the January 17 report out last night ahead of WOTE US 60 changes today. What we didn’t have time to delve into is where we could be wrong in our thesis that one should ride the best relative strength trends currently in place (i.e. the NDX Group) and no longer play contrarian with a large active share bet on weak relative strength trends that could reverse in the event of an offensive FED pivot (i.e. the Cyclicals Group) or recession (i.e. the Defensives Group).
Our #1 concern is the lack of confirmation from the small cap (SC) growth/value pair. This macro pair has languished while the large cap (LC) growth/value pair is quickly approaching prior highs. Most recently, this divergence foreshadowed a sharp decline in LC growth/value from late 2021 into late 2022.
The standout negative historical analog to this divergence is the 1999/2000 peak where the SC pair did not confirm the LC growth/value double top. The problem with the 1999/2000 analog is the 1995-1999 period just before it, where SC growth/value remained in a persistent downtrend while LC growth/value held up prior to exploding higher in the 1998-1999 period.
We believe macro context is critical here. In late 2021 the Fed was going on the inflation warpath and the interest rate landscape was about to roil 60/40. In 1999/2000 the US economy entered recession.
Today there is no recession and the Fed is in a more balanced posture to defend inflation upside and growth downside, a dynamic that limits both the economic reacceleration necessary for the Cyclicals Group to outperform and the economic deterioration necessary for the Defensives Group to outperform. But we will let relative strength trends be the final arbiter here. If the Cyclicals Group and/or the Defensives Group start/s to persistently outperform SPX at the expense of the NDX Group, we will adjust accordingly.
Second area of concern is valuation. Small caps are cheap relative to large caps. Not historically cheap, but cheap enough to warrant relative upside driven by a rotation out of LC growth and into small and large cap value.
This valuation-driven rotation into small caps is potentially supported by what looks to be a decisive topping pattern out of the large/small pair. The question is whether this is 2020 or 1997…
Again, we will let relative strength trends be the final arbiter, but weighing the broad evidence it is difficult for us to see small caps entering a relative strength uptrend from here after a pretty spectacular relative strength failure in the wake of a major breadth thrust signal…and given the Fed is now back in the game of defending inflation expectations.
WOTE US 60
As discussed in the January 17 report WOTE US 60 is not designed to be overly tactical. We positioned the strategy out of the gate (November 20, 2023 inception date) for a post-breadth thrust world of MAG493 outperformance on the back of the Fed allowing the economy to reaccelerate and we were slow to adjust in response to the Fed pivoting back again to defending inflation expectations. The reason we were slow is that the Fed began pivoting even before TIPS break-evens started moving higher. Now that break-evens are in fact pushing higher we can more confidently position for a relatively more hawkish Fed.
Most importantly, the fact the Fed so quickly moved to cut off an economic reacceleration after pivoting dovish in December gives us confidence that the next play beyond Tech is not the Cyclicals Group (unless it becomes severely oversold in a broad equity market correction perhaps into March), but rather the Defensives Group. With inflation set to reaccelerate and 2025 setting up to be an economic and market bloodbath as Powell seeks to rein in inflation ahead of his May 15, 2026 sell-by date, the Defensives Group is very, very likely to be a home run trade starting in 2H24.
For now, we want to concentrate portfolio active share in the NDX Group while keeping overall active share low. After today’s WOTE US 60 portfolio adjustment total portfolio active share is just 34%, 25% of which is Tech. This positioning provides us the best of both worlds: concentrated exposure in the most durable relative strength trends while 66% of the portfolio sits in reserve, ready to be deployed into high probability active share set-ups.
