Kevin Gordon is a senior investment strategist at Charles Schwab, and, more importantly, a co-OG winner of the FTAV charts quiz .
In markets it’s impossible to get through a day without being inundated with reasons as to why stocks are going up or down. Or why they should be going up or down. Everyone is always in search of a narrative.
Yet, in the past handful of months, the glut of narratives has grown exponentially, making it almost painful to try to characterise the current market. It’s human nature to demand to know what is responsible for any particular occurrence. But it’s also human nature to choose our own adventure, thus picking the narrative that best fits our own personal bias at the time.
The following list is not exhaustive, but at least captures the major themes that crop up in recent presentations, events, and conversations. Perhaps not surprisingly, these are all brought up in both positive and negative lights; each might be responsible for the next big market “melt-up” or “meltdown”.
As such, each narrative faces several holes, which means that — depending on how you look at it — either all or none of these helps explain what’s driving stocks. ¯\_(ツ)_/¯
Let’s tackle the big one first. The artificial Intelligence narrative has dominated the landscape for the better part of the past year. Investors have become excited (to say the least) about chatbots and chips, hoping that a massive productivity boom will ensue and revolutionise the world.
The exciting part is that this is a lot like the late 1990s with the advent of the internet. The worrisome part is that this is a lot like the 1990s with the formation of bubble-like behaviour.
Perhaps both are true, but the obsession of figuring out which parts of the tech world (the AI creators) will benefit the most is a bit odd. Looking at the 10 best performers in the S&P 500 since the start of 2023 and through March 2024, four are in tech, but three are in the industrials sector and two are in consumer discretionary. It looks like we’ve already seen the love shared for AI creators and adopters?
Speaking of the late 1990s, momentum has entered the chat. Now widely followed, momentum has surged to become one of the best performing factors this year (if you’re using the S&P 500 as your proxy).
Indeed, through the end of March, the S&P 500 Momentum Index was up by 22.3 per cent year-to-date. With the index having become highly correlated with the tech sector — and picking up steam like we saw in the run-up to the early 2000s tech bust — the bears are out in full force warning of a major bubble and looming “momo crash”.
However, things are different today. Back in the late 1990s the momentum factor was highly correlated with stocks that had negative earnings. Today, momentum is tied much more closely to companies that have stronger fundamentals, such higher returns on equity, free cash flow yields, and profit margins.
This one probably has the most poked holes in it, not least because two of the members (Apple and Tesla) are actually down by double-digit percentage points this year.
Even if you look back to performance in 2023, yes, the Mag7 did indeed lift the broader market considerably. However, not all members had magnificent performance (Apple finished in 63rd place).
Coverage of the Mag7’s performance might make one think that the group is the only game in town. However, since the S&P 500’s recent trough in October 2023, the Mag7 gained 37.6 per cent through the end of March 2024. The equal-weighted S&P 500 was up by 26.7 per cent — only slightly less than the cap-weighted S&P 500’s 27.6 per cent gain. In other words, the other 493 have not been left completely behind.
That strong equal-weighted S&P 500 performance means the “ broadening out ” narrative has now taken over.
Sectors that hadn’t been getting much attention — energy, financials, and materials, to name a few — are now starting to show more relative strength; if not in performance terms, then definitely in terms of underlying breadth.
Many investors are rejoicing that this is finally happening. This isn’t a recent phenomenon, though. The gains actually started back in October. In fact, from the October trough to the end of this past March, the best performing sector in the S&P 500 was financials.
One narrative that has shrivelled up this year is that the pricing out of Fed rate cuts for 2024 would coincide with a correction in the stock market.
On the surface, this hasn’t happened (at least in the large-cap world), given the S&P 500 rose by 10.2 per cent in the first quarter while the fed funds futures market went from pricing in nearly seven cuts to less than three. At a more nuanced level, there has been more corrective activity under the surface of indices like the Russell 2000: the average member has seen a maximum drawdown this year of -21 per cent.
This was a stronger narrative last year that has faded a bit in 2024. In essence, it’s consistent with the notion that the correlation between changes in stock prices and bond yields has turned negative: yields up, stocks down (and vice versa).
That negative correlation was quite strong in 2023 but has now softened; and in fact, as the S&P 500 rose by 10.2 per cent in the first quarter, the 10-year US Treasury yield rose from 3.88 per cent to 4.31 per cent.
It looks like we can have it both ways!
Just as the stock market has become more comfortable with higher rates, it seems like the same could be said of inflation.
Over the past couple years, the narrative of stickier inflation being a negative for stocks was born out of the fact that we had a bear market in 2022, just as inflation surged at a rate not seen in decades and the Fed was forced into aggressively hiking rates.
Regardless of whether you believe the last mile of disinflation is harder, we haven’t yet reached the 2 per cent goal. In fact, CPI — in year-over-year terms — has moved up from 3 per cent last June to 3.2 per cent as of this past February.
Whether that’s sticky inflation or simply trends rarely moving in a straight line is in the eye of the beholder, but the stock market has clearly shrugged it off for now.
Nothing is easy in markets, but one thing we can count on is looking at investor sentiment to gauge how much animal spirits are in control. And right now, they are very much in control.
Optimism is springing everywhere, evidenced by the high percentage of bulls in the American Association of Individual Investors survey, aggressive flows into equity ETFs, or the low equity put/call ratio (among other metrics).
Put simply, investors feel really good about the stock market, which makes them want to buy stocks. When those stocks do well, it makes them feel better, thus continuing the cycle. As we’ve learned throughout history, periods of optimism and exuberance eventually end (sometimes messily) but trying to time that is a fool’s errand, since they can last for a while.
Maybe the market simply has no regard for whatever narrative we choose?