Markets Consolidating, Awaiting the Next Catalyst…
Executive Summary:
Market Consolidation & Broadening Breadth: The S&P 500 is experiencing a healthy, directionless consolidation phase driven by improving market breadth, which is highlighted by a historic first-half performance for small-caps and a notable technical pullback in the semiconductor space.
Macro Disconnects & Earnings Resilience: Despite softening economic data, rapidly easing inflation expectations, and reversing oil prices, the bond market and the Fed remain unexpectedly hawkish; concurrently, Q2 corporate earnings estimates are seeing robust, early-cycle-style upward revisions.
Equity markets outside the US & Commodities: Asia ex-Japan equity markets have become even more concentrated than US indices as their fate gets ever tied with the AI renaissance. The long-term outlook remains firmly intact for uranium (driven by the nuclear renaissance) where underexposed investors can take advantage of a correction that is showing signs of ending, and a thought on gold which is showing signs that it may be in the final stages of a bottoming process.
Full Commentary:
It’s been nearly two months since the S&P 500 first breached the 7,500 level (May 14th), and over a month since it hit its all-time closing high of 7,609 on June 2nd. Since then, it's been a lot of directionless chop (both up and down) as the previous catalysts / narratives get fully priced in or out (AI renaissance and all its adjacent industries, Iran War, debasement trade, capex spenders vs. receivers, inflation accelerating…). Although I’d argue this is a very healthy consolidation, as it’s been the broadening out of market breadth that’s kept markets at bay while the highly concentrated Mega-Cap Tech companies have been under pressure.
The improving breadth was on full display last week as the Invesco S&P 500 Equal Weight ETF gained +2.2% and hit a record high on Thursday. The same for the small-caps. Even though the Russell 2000 dipped for the week, the index just finished its best first half of a year since 1991, gaining 22% compared to the S&P 500's 10%. This marks just the third time in the past four decades that the Russell has outperformed to such an extent during the first six months of the year, which does seem strange given that the markets also believe that the next move by the Fed will be to hike and that the Atlanta Fed has marked down Q2 real GDP growth to just +1.2% annualized from +3.0% a month ago. Small-cap stocks tend to feed off lower rates and stronger growth.
As for the major benchmark indices, the S&P 500, Nasdaq Composite, and Dow Jones Industrial Average, they all gained roughly 2% on the week. On a sector basis, semiconductors and many AI hardware stocks had ugly downside reversals for the week – several broke below key support levels. Semis are coming off their worst two days in over a year (down -10%) with the timing of the decline a bit peculiar, as the session before a long weekend is normally a ghost town. Instead, the chip ETF traded 1.5x the prior day's volume. It leaves you with the impression that someone wanted out badly enough to sell in size right before a 3-day break. As depicted in the chart below, semiconductor stocks have now closed below their 20-day moving average for 2 consecutive days, the longest stretch since March.
All Mag 7 stocks except Alphabet and Apple have lagged the S&P 500 this year. The standout sector has been semiconductors, with the SOX Semiconductor Index up +78% YTD. In the sector’s history, only one full year exceeded that return, which was 1999 when it rose by +101%. But remember what happened next because, as is the case now, through much of 2000 the market did broaden out – until it didn’t, in the fall of that year. The market is hanging in because wide swaths of the rest of the market are performing admirably of late, including Health Care, Transportation, Aerospace, and Financials (Software too). As I stated in last week’s missive, I’m inclined to fade the parabolic bid in Semis in favor of adding exposure to some of the hyperscalers that have become beaten down. This gap between "hyperscalers/funders" and "semis/beneficiaries" is enormous, but last week’s price action provided a glimpse that perhaps the market is moving to close part of this performance gap.
You can see in the chart below the trends in the green and red lines starting to reverse in late June.
Don’t get me wrong, I’m not a bear on those industries and sectors that have benefited from the huge hyperscaler capex spend, but those thinking this parabolic rise will continue at its current pace are deluding themselves. My overall view on the equity market at this moment is best synthesized by Carter Worth’s “pair of twos” analogy – not strong enough to bet big, nor weak enough to fold. So, you have to play the hand, but be mindful of sharks. The bullish view does have a solid set of variables acting as a tailwind: (1) price momentum, (2) an epic acceleration in consensus earnings estimates, (3) a constructive technical picture, (4) supportive flows, and (5) a President who sees the stock market as a barometer for his performance, which has many investors believing that he will never allow anything more than a wobble.
As for the earnings backdrop, which is set to kick off in a little over a week, the consensus is now expecting S&P 500 earnings to rise at a roughly 25% pace in the coming year. Analyst estimates for Q2 are following a similar pattern to Q1, where during Q2, analysts increased EPS estimates for the quarter by 3.4%, the most since Q2'21. Six sectors saw a rise in estimates led by Energy (+61.5%) and Tech (+8.7%).
What remains interesting is that you typically see analysts cut estimates ahead of earnings, as companies guide cautiously, but that hasn’t been the case this year. The big step-up in upwardly revised forecasts for 2026Q2 has come at a pace typically seen after recessions or at the beginning of new economic cycles – not in the fourth year of a new bull market phase.
Moving on to bonds and interest rates, the 10-year Treasury yield jumped +11 basis points last week to nearly 4.5%, and the move looked out of step with the data. Warsh did not sound hawkish at Sintra, and the slew of economic data reported last week – between ISM, consumer confidence, and jobs – leaned more towards dovish Fed policy than in the hawkish direction. Not to mention that anyone with a reasonably accurate inflation nowcast model can see that future inflation prints are set to come down meaningfully into the Fall. Add to this market-based inflation expectation numbers have come down to just over 2.2%, and you have yourself a recipe for Fed cuts coming back into the discussion, not hikes. Oh, did I mention that U.S. crude oil futures dipped to $68 a barrel, where 92% of the wartime surge in oil prices has now been reversed, but only 25% of the spike in the 10-year T-note yield has been retraced.
We are seeing the number of tankers moving through the Strait of Hormuz increasing to 30 – 60 ships a day, with the flow of traffic accelerating in early July. This is less than before the war, but enough to relieve pressure on consumer budgets and fuel budgets in the transportation industry. The question is, when will the Fed and the bond market realize that the primary inflation threat has gone away? Despite the collapse in oil prices, the downgrading of economic growth estimates, and no sign of acceleration in wages, the Warsh-led Fed, in the interest of doing away with forward guidance, has been ratifying market expectations of a rate hike coming our way soon.
This was the case with last week's jobs report as well. The interest rate market fixated on the dip in the unemployment rate in June to 4.2% from 4.3% in May and was willing to ignore most of the rest of the jobs report, which was rather weak. As such, investors continue to believe that a rate increase by the end of the year is a near-certainty, and is a coin toss for a hike by the September meeting. Since the start of the year, markets have shifted from anticipating two cuts to one hike, which has translated into this total reset of the Treasury curve, and worthy of a 50+ basis point surge in the 10-year T-note yield since the end of February. The question is — what really has changed for the Fed under current circumstances, and when will it begin to pivot the other way? It certainly wouldn’t be the first time, with the Powell-led Fed back in late 2018 being the most recent parallel. Back then, it was Powell’s comment that ‘we are a long way from neutral’ that got the markets offside in the hawkish direction, only to reverse that view in short order with the Fed cutting rates three times by October 2019.
Another piece of data that is worth monitoring for investors with a longer-term view is what the polling numbers are showing for this Fall’s mid-term elections. I know, I know…you have to interpret polling data with a grain of salt (which I don’t disagree with), but assuming they aren’t complete garbage, they reveal a President’s approval rating that is having a hard time getting off the mat – especially with Independents, who are likely to determine the outcome this Fall. In regard to November’s midterms, the Democrats now command a 6-point lead over the GOP — 44% to 38% support. The lead builds on a 4-point lead a month ago. These results were prior to the release of the President’s financial winnings, which showed an incredible $2.2 billion intake last year, at a time when many Americans are struggling, and the low-end is living paycheck to paycheck. This all plays into Greg Ip’s excellent column today titled Founders’ Democracy Frays at the Edges on page A2 of the Wall Street Journal. To wit:
“The repercussions could outlast Trump. The Democratic Party is being pulled leftward by progressives and socialists determined to go after wealth and corporate power. Thanks to the pathway blazed by Trump, a future Democratic president will face fewer checks and balances to carrying out such an agenda.”
The point I’m trying to get at is less political and more about markets, where a significant swing from a GOP to Democratic majority will represent a big turn in fiscal policy. A turn that now doesn’t appear as though it would be in a pro-business fashion. Look, I’m not arguing pro and con – I’d be the first to admit that the system as it exists today is broken for many and needs some deep structural reform to stop it from spiraling – but a shift in fiscal policy towards the progressive/socialist framework is not priced into the market. Not saying it will happen, but this risk potentially lies around the bend and will likely prove to be market unfriendly if it comes to pass.
Let’s end with some closing thoughts on markets. There seems to be a delicate balancing act playing out with equities, where it’s the AI trade or anti-AI trade that works on any given day. It's an either-or thing; rare is the day when they both work at the same time. Jim Bianco has been all over measuring and mapping this dichotomy. With Q2 earnings season set to kick off next week, I’m looking forward to learning more about how companies are evolving their approach/usage of AI into their business models. I must admit that I’m a bit nervous as to whether aggregate earnings will meet or exceed the high expectations bar that has been set going into Q2 reports. As such, I’m not expecting many fireworks from the actual results. If they meet elevated estimates, I’ll consider it a win, with fundamentals validating where price levels and valuation multiples already are. Not that they both couldn’t move higher, but I think we’ll need to see estimates exceeded and solid guidance to drive a considerable leg higher.
Looking across the globe at other equity markets, I recently liquidated our Asia ex-Japan position in portfolios as the concentration in Korea and Taiwan became too much as they represent approximately 70% of the global semiconductor production capacity – we’re talking mostly about three companies here, SK Hynix, Samsung, and Taiwan Semiconductor). Not to mention the region is up roughly 40% over the past year and over 20% over the past 3 months, with a lot of good news already priced in. For additional context on the concentration factor, consider this: the most widely followed emerging markets benchmark is the MSCI Emerging Market Index, which has seen its weighting in China drop to the #3 spot behind Taiwan and South Korea, even though China’s economy is 25x larger than Taiwan's and 11x larger than South Korea’s. All that said, our work has us gravitating towards the world where there are catalysts beyond the AI renaissance, areas that will benefit from lower oil prices, positive rate of change inflections in growth and/or inflation dynamics, and an improving fiscal impulse. That would include China, India, Japan, and Latin America.
As for the commodity markets, the nuclear renaissance continues uninterrupted, with no less than a dozen Small Modular Reactor designs moving through the pilot stage, with the expectation for some to be viable energy solutions as early as 2027. We remain constructive on this space even though uranium (one way that we’re expressing our exposure) has been mired in its annual 25% drawdown. I’m seeing some constructive developments in the charts with divergences and RSI readings suggesting the bulk of the correction has run its course. Those investors with a time horizon that extends beyond their nose are getting an opportunity to enter a long-term theme that still has plenty of tailwinds.
As for gold, I’m still of the view that every diversified portfolio with a total return objective should have some exposure. It’s been quite a correction in the yellow metal since its parabolic peak that pushed the price beyond $5,500/oz at the end of January. Call it a healthy cleansing of the momentum and ‘Johnny-come-lately’ crowd. Central bank buying, currency debasement, and foreign exchange reserve diversification (ever since the US sanctioned Russian reserves after it invaded Ukraine in 2022) are as relevant tailwinds today as they were four years ago when this gold bull market got underway. Recent data on central bank purchases shows the big selling in March was an exception (to defend their currencies during the Iran War) rather than the norm — the official data show that in May, central bank gold reserves expanded by +41 tons, the most since last November. Be that as it may, what we saw unfold over the past two weeks was little more than a floor being established under the price at around $4,000 per ounce. That is the first sign of a real bottoming process since the January peak, but beware that if the $4,000 per ounce support level doesn’t end up holding, we are talking about the next level of support being $3,250 per ounce, which is more than -20% away from where we are now. So, it's not a slam dunk, but my read of the setup suggests it’s a favorable risk/reward as long as the price doesn’t break through $3,800 to the downside.
Please note: Capital Market Musings & Commentary will be taking a brief hiatus next week, but will be back with a fresh missive the following Monday.
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