Market insights and analysis

By Will Hubbard

The major U.S. stock indexes rose last week on strong economic data. The Russell 2000 small-cap index added 3.56%, technology stocks pushed the NASDAQ to a 3.32% gain, the S&P 500 increased by 2.42%, and the Dow Jones Industrial Average rose 2.29%. The 10-year Treasury bond yield fell 23 basis points to 3.83%. Spot gold closed the week at $1,955.21, up 1.57%.

Stocks

Last week’s equity gains were driven by encouraging economic data, with the consumer price index (CPI) at the forefront. Updated CPI figures saw decreases in both the headline and core CPI. The headline number slid from 4% one year ago to 3%, and core CPI decreased from 5.3% to 4.8% over the past year.

On Thursday, jobless claims and new producer price index (PPI) data came in strong, supporting the narrative of a possible “soft landing” (the scenario in which the Federal Reserve lowers inflation without sparking a recession). Despite the current high interest rates, jobless claims came in at 237,000, below the revised level of 249,000 from the previous week. The PPI for final demand prices decreased by 0.4% in May but rose 0.1% over the past year due to consistent increases in service prices.

The Federal Reserve increased interest rates over the last year with the expectation that CPI would simultaneously decrease in a way that would create a “soft landing” for the economy. This was communicated to both professional and retail investors. This messaging, along with recent declines in CPI, has driven consumer sentiment to new highs.

In a statement, Joanne Hsu, director of the University of Michigan’s Surveys of Consumers noted, “Consumer sentiment rose for the second straight month, soaring 13% above June and reaching its most favorable reading since September 2021. All components of the index improved considerably, led by a 19% surge in long-term business conditions and 16% increase in short-run business conditions. Overall, sentiment climbed for all demographic groups except for lower-income consumers. The sharp rise in sentiment was largely attributable to the continued slowdown in inflation along with stability in labor markets.”

According to investment and market research firm SentimenTrader, such two-month surges in consumer sentiment have historically led to gains for the S&P 500 over the subsequent six months 91% of the time.

As discussed in recent Weekly Update articles and highlighted in J.P. Morgan’s most recent “Guide to the Markets,” the concentration of the largest 10 stocks in the S&P 500 is at an all-time high at 31.7%.

SentimenTrader calculated the returns by sector on both equal-weighted and market-cap-weighted approaches following increases of 10 points or more over two consecutive months. While returns were favorable across multiple periods, the difference between the equal-weighted and market-cap-weighted approaches was notable.

SentimenTrader found that the equal-weighted S&P 500 approach outperformed the market-cap-weighted approach over the next year. The firm also found the equal-weight Technology sector outperformed the market-cap-weighted Technology sector by over 6%.

However, some professionals consider sentiment to be a bit contrarian, suggesting that investor risk rises as investors become more bullish and pile into equities. In other words, the more everyone takes the same view, the higher the risk of a reversal. Some indicators point to this risk.

The heightened level of optimism combined with rising price-to-earnings (P/E) ratios seems to indicate the market is pricing things perfectly. The S&P trades at a forward P/E of 19.1 compared to the 25-year average of 16.8.

As a frame of reference, the forward P/E at the end of 2021 was 22X before the drawdown in 2022. The main difference is that in 2021, the Federal Reserve had a zero interest rate policy (ZIRP) and 20-year bonds were trading at 2%. Interest rates rose and bond prices plunged, forcing banks such as Silicon Valley Bank (SVB) into insolvency.

In 2021, with ZIRP in play, there were few attractive alternatives to equities. Now, the bond market is a more appealing option, with one-year Treasurys paying around 5.3% interest and 20-year bonds over 4%.

Activist investor Arnaud Ajdler of Engine Capital sees the S&P 500 risk premium declining to dangerously low levels. In a recent quarterly letter, he suggests that the S&P 500 earnings yield (the inverse of the P/E) should provide some additional premium over the risk-free rate. If the forward P/E is roughly 19.1, the earnings yield should be 5.2%, which should be higher than Treasurys. Otherwise, why would you invest in equities?

Despite some cautionary indicators, there is reason for optimism within equities. History offers valuable insights, although past performance doesn’t guarantee future results. As we enter the third quarter of the year, the importance of active risk management in navigating market risks and identifying promising opportunities cannot be overstated.

Bonds

Bond yields declined from 4.06% to 3.83% last week and remained heavily inverted. Fortunately, an environment of declining interest rates favors equity investors as it widens the gap in the equity risk premium based on the earnings yield.

Despite the decline, yields rose on Friday as expectations for consumer inflation grew, albeit modestly. This mild inflation is likely due to the anticipated halt of the Federal Reserve’s cycle of interest-rate hikes.

Gold

After rising 1.57% last week to just below $2,000 per ounce, gold is still off its all-time highs. Gold’s performance is known to be capricious, and history shows its value can remain stagnant over years or change significantly within a short period.

Gold is often hailed as an effective inflation hedge and store of value, which makes it attractive to investors fearing an economic downturn. A recent article from Doomberg, a financial publication on Substack, emphasized this relationship in the context of energy and efforts by countries outside the U.S. to diminish the dominance of the U.S. dollar as the global reserve currency.

The authors refer to a recent tweet by the Russian embassy in Kenya that states that 41 countries are interested in creating a new currency backed by gold. The inference is that if any organization or government tries to create a new currency backed by a hard commodity like gold, it could lead to a bullish scenario.

Tying a currency to gold may seem appealing, but the challenge of implementing it and the need for an agreement among those 41 nations makes this a steep hill to climb. This doesn’t even consider the significant number of Eurodollar bonds held by most emerging market nations.

Emerging economies use Eurodollar bonds to protect lenders from devaluations of local currencies by issuing debt in U.S. dollars. This massive market undoubtedly influences those who wish to challenge the supremacy of the U.S. dollar.

The article ends by summarizing the important role gold plays as a wealth-preserving asset. Despite differing viewpoints on gold, the experts interviewed agree that displacing the U.S. dollar would be challenging, and such a move would substantially affect the price of assets such as gold.

For more information about investing in gold, including its diversification benefits, please check out FPI’s white paper, “The role of gold in investment portfolios” (for financial professionals only).

Flexible Plan Investments is the subadviser to the only U.S. gold mutual fund, The Gold Bullion Strategy Fund (QGLDX), designed at its introduction 10 years ago to track the daily price changes in the precious metal.

The indicators

The very short-term-oriented QFC S&P Pattern Recognition strategy started last week 80% long. On Monday’s closed, it moved to 160% long. On Tuesday, it changed to 50% short. It moved to 120% short on Wednesday’s close, to 170% short on Thursday, and back to 120% short on Friday. Our QFC Political Seasonality Index started last week in risk-off mode. It switched to its risk-on positioning on Tuesday’s close. (Our QFC Political Seasonality Index is available—with all of the daily signals—post-login in our Weekly Performance Report section under the Domestic Tactical Equity category.)

Our intermediate-term tactical strategies have been varied in their degree of defensive positioning. The key advantages these strategies offer to investors are their ability to adapt to changing market environments, participate during uptrends, and adjust exposure to more defensive posturing during downtrends.

The Volatility Adjusted NASDAQ (VAN) strategy started last week 160% long, moved to 180% long on Tuesday’s close, shifted to 200% long on Wednesday, and remained there to finish the week. The Systematic Advantage (SA) strategy started last week 30% long, increased exposure to 90% long on Thursday’s close, and increased to 120% long on Friday. Our QFC Self-adjusting Trend Following (QSTF) strategy was 200% all week. VAN, SA, and QSTF can all employ leverage—hence the investment positions may at times be more than 100%.

Our Classic model was in a long, risk-on position all week. Most of our Classic accounts follow a signal that will allow the strategy to change exposure in as little as a week. A few accounts are on more restrictive platforms and can take up to one month to generate a new signal.

Flexible Plan’s Growth and Inflation measure, one of our Market Regime Indicators, shows markets are in an Ideal economic environment stage (meaning inflation is falling and GDP is growing). Historically, an Ideal environment has occurred 28% of the time since 2003 and has been a positive regime state for stocks and bonds. Gold tends to underperform both stocks and bonds on an annualized return basis in an Ideal environment and carries a substantial risk of a downturn in this stage. From a risk-adjusted perspective, Ideal is one of the best stages for stocks, with limited downside.

The S&P volatility regime is registering a Low and Falling reading. From an annualized return standpoint, low and falling volatility favors stocks over gold, and gold over bonds. The combination has occurred 37% of the time since 2003. Typically, this stage is associated with higher returns and less volatility from equities and bonds.