What a fascinating time we find ourselves in! The headline I selected a few weeks ago feels particularly relevant today, especially in light of the “largest IT outage in history.” Following the close of the second quarter in June 2024, we felt compelled to reflect on our positive performance and refine our strategies after observing several disconnects in the financial markets, both technically and fundamentally.

Starting in early July, we raised our cash exposure to 25% across all portfolios. In the upcoming sections, I will highlight key technical and economic indicators that we are closely monitoring as we navigate this dynamic landscape.

The U.S. economy is showcasing remarkable resilience, fueled by a combination of powerful forces:

• Unstoppable consumer spending: A surge in service expenditures has created a formidable shield against potential downturns.
• Unrelenting government spending: Recent legislative measures have unleashed a torrent of capital, invigorating the economy.
• Soaring corporate earnings: Robust corporate performance continues to elevate the overall economic landscape.
• Wealth effect phenomenon: Skyrocketing asset prices in the stock and housing market have ignited a wealth effect, driving a wave of consumer spending and investment.

Amidst this dynamic backdrop, we believe that more relaxed financial conditions have a good chance of offsetting the impact of any unexpected Fed rate hikes for the next few quarters and the party in the equity market can continue. The much-anticipated decrease in interest rates has yet to be seen, but widely forecasted.

At the beginning of July, the equity markets began  indicating a likely pullback. Considering the impressive rally since October 2023, it is prudent to protect our gains while seeking new opportunities..

Our move to 25% cash over the past month makes room for this strategic adjustment.

Below is our rationale:

1. Technical indicators, are signaling extreme overbought conditions.

Example 1: RSI

• The S&P 500 14-day relative strength index (RSI) surged above 81 on Wednesday, July 17th.
• This coincided with the S&P 500 surpassing 5,600 for the first time in history.
• An RSI above 70 signals an asset is overbought, hinting at an impending pullback.
• Conversely, a reading below 30 suggests oversold conditions, typically preceding a rebound.
• The RSI ranges between zero and 100, with extremes often heralding market reversals.
• The performance of a select few stocks may be skewing our perspective.
• Technical indicators are going haywire, and the signs are too strong to ignore.
• An RSI above 81 for the S&P 500 is rare, witnessed only 12 times in the past 40 years.
• Historically, these moments have been the calm before the storm, often followed by dramatic market plunges.

Example 2: Market Breadth and Performance

• The last few trading days showed positive mean reversion in market breadth.
• The preceding six months were a bloodbath.
• Market ascent driven by a handful of mega-cap stocks.
• The average stock plummeted 4-5% in Q2.
• The S&P’s cumulative A/D line has lagged behind the price all year.
• Only two sectors have outperformed the broad S&P in the past year.

Example 3: Buffet Indicator

• Warren Buffett’s cherished market valuation metric: the ratio of total stock market cap to GDP.
• US stocks now have a combined market cap exceeding $56 trillion.
• GDP lingers at $28.3 trillion, creating a staggering ratio of 2 to 1 (200%).
• This ratio surpasses its peaks in 2000 and 2021.
• According to this metric, the stock market teeters on the brink of a pullback.

Economic Indicators are Showing Cracks

Despite the resilient facade of the U.S. economy, there are underlying indicators revealing potential vulnerabilities. Here’s what we’re observing:

Example 1: Job Growth Remains Steady, But Unemployement is Concerning

• Job growth remains steady, but rising unemployment is concerning:
• Historical trends show increasing unemployment rates often accelerate.
• The Sahm Rule (recession indicator) hasn’t triggered yet but is close.
• The time it takes for workers to secure jobs is increasing.

Example 2: Housing Market Shows Resilience, But is Slowing

• Housing market shows resilience but is slowing:
• Housing affordability is worsening when considering income and financing costs versus home prices.
• At current mortgage rates and wages, it takes 72 hours of work to make a monthly payment.
• If mortgage rates were 5%, it would still take 58 hours.
• A 20% down payment requires 2,696 hours of work at current wages, near record highs.

Example: 3 Small business sentiment has slightly improved but remains very low:

• Sentiment levels are comparable to those during the Financial Crisis.
• Capital expenditures, crucial for growth, continue to decline.
• Contrasting sentiments between consumers/small businesses and investors:
• Consumer and small business sentiment is bleak.
• Investor optimism is high, a potential red flag.
• Investors Intelligence survey shows a low percentage predicting market corrections.
• AAII Bullish sentiment’s 12-month average is at its highest since November 2007.

Example 4: The U.S. Manufacturing Purchasers Index has been stuck in contraction for most of the last two years, signaling a decline in goods production.

• The global outlook doesn’t fare much better, with contraction gripping every month from September 2022 to February 2024.
• This points to at least a recession in manufacturing activity.

The momentum in bonds is beginning to surge in anticipation of interest rates decline, signaling a pivotal shift in the financial landscape. Our instinct tells us that current rate levels are temporary. We are seeing a significant shift back into bonds and have adjusted our portfolios accordingly. The appeal of these yields allows us to adopt a patient approach.

Even if we’re slightly ahead of the curve, we embrace the risk of being early over the peril of being late. Moving away from overinflated equities might mean missing out on some exuberant gains, but such is the calculated sacrifice we make as prudent stewards of wealth.

As we observe the widening economic cracks, it’s essential to stay vigilant and adaptable in our investment strategies. Our bolstered cash position equips us with the flexibility needed to navigate potential market upheavals effectively. The landscape is constantly evolving, and while we maintain a cautiously optimistic outlook, we are prepared to adjust our approach as new data and trends emerge. In the second half of 2024, our aim is to balance caution with opportunity. By increasing our cash allocation, favoring bonds, and closely tracking economic indicators, we intend to protect our gains while exploring new avenues for growth. Although political and geopolitical uncertainties may not directly influence our decisions, they do prepare us for the unexpected—such as the tech outages we experienced today. We encourage you to join us on this journey. If you have questions or need tailored advice, please reach out.