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Domestic Equites have had a busy week. From yesterday’s Fed rate hike decision, 2nd quarter GDP coming in higher than expected today, and a slew of household names reporting earnings this week it doesn’t seem like there could be a more action-packed week for the market. All things considered, results across the board have been mostly positive. Strong earnings from META & GOOGL highlight a continuously strong tech focused market, and positive results from Boeing (BA) pushed the Dow Jones Industrial Average .DJIA to tie (but unfortunately not break…) its longest daily gain streak in history. The one hang-up from a macro perspective seems to be a continuously strong labor market, leaving the door open for future rate hikes, which would hinder the equity space and drive concerns that further tightening could jeopardize the chance of a soft landing.

The domestic equity rise has provided a nice break from discussing the international space, which we certainly covered at length throughout the last quarter of 2022 and first of 2023 as the space roared forwards in the face of domestic declines. That certainly isn’t to say that the space hasn’t had its fair share of notable technical improvements, however. From a macro perspective, the space has been aided by a technical breakdown from the US Dollar DX/Y, but it is worth noting that inflation globally has been a bit stickier than we have found here in the US. For now, the former has been the market's main focus, with the broad space maintaining its relative strength across both DALI and the Asset Class Group Scores (ACGS) page. Within the group, a variety of areas have been actionable throughout the year, although we have mentioned a number of times the current preference for developed markets. Developed markets proxy EFA is outperforming emerging proxy EEM by just roughly 3.5% since the start of 2023. This theme is echoed by each fund's respective fund score (EEM’s 3.58 vs. EFA’s 4.18), which suggests developed markets remain resilient. Throughout the course of July, however, EEM has outperformed SPX and EFA by over 1.2%, suggesting some aspects of near-term strength. This strength was enough to see EEM post a second consecutive buy signal and move to new rally highs.

But is this outperformance for the emerging space simply a bump in the road or a sign of changing tides? While no one indicator is a “silver bullet” as they say, one aspect which we typically use as a judge of where we stand from a historical standpoint between two groups are performance spreads. With this in mind, one can run rolling 6-month performance spreads between the funds in hopes of identifying patterns that arise. As seen in the chart below, there does seem to be an emerging cap around the 15% outperformance of EFA in favor of EEM, at which EEM begins to outperform. Remember, an uptick in outperformance for one group does not necessarily mean one group is falling while the other is rising (as both can be moving higher/lower, just of different magnitudes…) but it is notable nonetheless. All things considered, keep an eye on emerging markets and their strength over the coming weeks to see who can hold the strength within the international space. 

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The Federal Reserve concluded its July meeting yesterday (Wednesday, 7/26) and raised the federal funds rate by 25 basis points, as had been widely expected. In the press conference following the meeting Chair Powell said that the FOMC’s decisions about future rate hikes would continue to be data-driven. With June CPI reading showing that inflation has continued moderate, there has been speculation that this could be the final hike in the Fed’s tightening cycle. Fed futures are currently pricing in a 70% chance that the federal funds rate will be at or below its current target of 500-525 basis points at year-end.

It’s a given that the end of the Fed’s tightening cycle would be a welcome development for bond investors. But today, we wanted to take a look at which other areas of the market might stand to benefit (or struggle) if rates begin to decline. The table below shows the correlations of the two-, five-, and 10-year US Treasury yields to the 11 S&P 500 sector indices, the SPDR Gold Trust (GLD), the iShares Silver Trust (SLV) and the S&P GSCI Commodities Trust. All else being equal, we would expect those assets with positive correlations (in green) to perform better when yields are rising and those with negative correlations (in red) to perform better when yields are falling.

One of the first things we see is that most of the S&P 500 sectors have weakly positive relationships to yields; although rising yields are often talked about as a headwind for equities due to higher borrowing costs and their effect on valuations, rising yields are most often seen during periods of economic expansion, periods when we also expect equities to perform well. Two sectors – energy and financials – have relatively strong correlations to yields. The basic business model of banks is to borrow on the short end of the curve and lend on the long end and spreads between short- and long-term yields are generally wider when yields are higher, helping to boost banks’ profits. The energy sector’s relatively strong positive correlation to yields is likely due to the increased demand for energy during periods of economic expansion as opposed to a direct relationship to profitability.

On the other end of the spectrum, utilities and real estate are the sectors that show the strongest negative correlations to yields and therefore would be expected to be among the sectors most helped by falling yields. For real estate investment trusts (REITs), lower rates mean lower mortgage payments and higher profits. Additionally, both REITs and utilities typically carry above-average yields and are therefore more attractive to yield-seeking investors.

Gold shows a stronger relationship to yields than any of the 11 equity sectors, and interestingly, has had a significantly higher correlation to yields than silver has over the last five years. When yields are lower, especially when real yields are near zero or negative, precious metals are relatively more attractive as a store of wealth as investors earn relatively little (or even lose money in real terms) by investing in Treasuries. As to why gold has exhibited a stronger inverse relationship to yields than silver, this may be due to silver having more industrial uses, making its price less dependent on its attractiveness as a store of wealth. It is worth pointing out that commodities at large do not exhibit the same inverse relationship to yields, as the table shows the S&P GSCI Commodities Trust (SPGSCI) shows a positive correlation to short- and long-term yields.

Unlike fixed income, where interest rates are the most important driver of prices for most segments of the market, the direction of yields is a secondary consideration for equities. Even for those sectors showing relatively high correlations to yields – like financials and utilities – there are more important drivers of performance. So, it would be imprudent to base an investment based only on an opinion about the direction of yields. Currently, utilities and real estate, the two sectors most likely to benefit from a decline in yields rank ninth and 11th in the DALI sector rankings respectively, squarely in underweight territory. Furthermore, at this point, there is no technical evidence that a decline in US Treasury yields is imminent. The US Treasury 10-year Yield Index (TNX) remains on multiple consecutive buy signals and crossed above 4% again on Thursday following the stronger-than-expected Q2 GDP numbers.

 For those intent on trying to front run a potential move in interest rates, the SPDR Gold Trust (GLD) may be the most attractive option as it has an already sound technical picture to which a potential decline in yields could be an added tailwind. The fund currently has a favorable 4.19 fund score, which is 0.75 points better than the average for all precious metals funds. GLD returned to a positive trend on its default in January and is currently in the action phase of a potential shakeout pattern, which would be completed with a triple top breakout at $1920. $176 could be considered as a potential stop-loss and it would violate the potential shakeout pattern.

Domestic equities have roared back in 2023 led by some of the largest names putting up triple-digit returns like Tesla (TSLA), Nvidia (NVDA), and Meta (META). This has led the S&P 500 Index Funds group to reach an average score of 4.70 for only the third time in its history dating back to 2004. The other two periods when the group reached a score of 4.70 was in February 2020 and then a few times from August to November 2020. While both these periods were followed by big moves, one in each direction, it does show how narrow the equity market is right now. The Equity Core Percentile Rank has sat around 98% since the end of May meaning that the S&P 500 Index Funds group has scored higher than 98% of all groups tracked for nearly two months. This doesn’t mean the market is headed for disaster but rather that the narrowness of the market will have difficulty lasting much longer. Both average score for the S&P 500 Index Funds Group and the Equity Core Percentile Rank have reached these levels before, but they typically do not last for a long period. It would be expected that there will be some broadening out of the market or at least a few groups that begin to challenge the core of the market.

On the exact opposite side of the coin, the All US Fixed Income Group is scoring close to the 2.0 level, an area rarely visited for very long. The weakness in the fixed income space has been on the heels of the most aggressive Federal Reserve rate hiking cycle in recent history. Coupled with the strength in equities, fixed income groups mostly lack any relative or absolute strength. However, given the group’s current score there could be some contrarian opportunities. For example, if some clients need to do a change in allocation due to their age or they’re close to retirement, then now might be a good time to think about having those conversations. Touched on in more detail in today’s featured article, it does appear that the Fed is near or at the end of its rate hiking cycle which may give some respite to the fixed income space. The asset class is still one to avoid overweighting for the time being, but for those that need exposure, it’s not the worst time to dip your toes in at these levels.

Daily Option Ideas for July 27, 2023