Bonds vs Stocks; Macro vs Big Tech

Paid subscriber analysis

After a few key events have all now passed - the FOMC meeting, the Treasury’s QRA, February OPEX (option expiry), and the latest inflation reports (both CPI and PPI) - it is a good time to reflect on how the market reacted to each of these, and what it might mean for the weeks and months ahead.

This whole week was quite turbulent. Monday kicked off into new highs, and then pulled down, making way for a pretty sharp sell-off on Tuesday after a hotter than expected CPI report. It failed to sustain, however, as we saw rallies on both Wednesday and Thursday, completely reversing the Tuesday move. The first 2% sell-off in the SPX for a very long time, and it lasted half a day (the bounce back started already in the final hours on Tuesday). The bullish flows are as powerful as ever. Not even a bad PPI in the midst of the Friday options expiry could initiate a stronger reaction. The close was a 0.5% decline in SPX, yet we are still dancing close to all time highs. It was just like after FOMC two weeks ago. A sharp sell-off was simply not sustained.

All this happening during a significant repricing of Fed interest rate probabilities. Two weeks ago, markets were pricing in 6 cuts for this year. Now we are already down to barely 4. And the equity markets keep pushing higher and higher. Or at least, one part of the equity markets keeps pushing higher.

Today we talk about:

1. The divergence between bond and stocks (the equity premium)

2. Macro conditions versus Big Tech

3. R*, the neutral rate of interest - is it higher now (for longer)?

4. Opening the window of weakness post options expiry - for how long are we in danger?

Each issue is very important in helping us understand the shape of markets ahead.

Bonds vs stocks, and the equity risk premium

The outcomes from the most anticipated fiscal and monetary decisions this year, the QRA and the FOMC, sent out clear bearish vibes. Higher expected supply of bonds, and taking the March (and soon even the May) interest rate cut off the table should have pushed markets down just like it did back in August last year.

That was, at least, the immediate reaction. The bond market got the message, as yields keep pushing up and bonds keep selling off after QRA (greater than expected supply > lower price > higher yields). But for equities, even the rate cut repricing wasn’t enough. We keep pushing into all time highs week after week.

Bonds are down again, gold is also down, but SPX and NDX show no signs of stopping. There is already 10% gap between SPX and TLT (long-term bond ETF) in just these first 6 weeks of 2024. So if you have a 60/40 portfolio, you’re basically flat for the year.

And if you’ve been following the newsletter over the past three years, you might have noticed that we often show this divergence between bonds and stocks. Not just for the US, but globally. Take a look at the following chart from the FT:

In 2021, stocks outperformed during the bull run - as expected, of course. In 2022, both bonds and stocks sold off, as bonds failed to provide the cushion for falling equities during periods of high inflation. This is the main logic behind a 60/40 portfolio and the very idea of the equity risk premium - equities almost always outperform bonds, but they do so at a greater risk.

To control the risk you need bonds in there, especially since they soften the blow during recessions. When recessions happen, bonds go up (interest rates go down), and this has to offset the equities sell-off. Simple, right?

This relationship, almost a stylized fact for the past 40 years, is being torn apart by this whole post-COVID shock of high inflation, massive fiscal stimuli and huge debts and deficits that hardly anyone seems remotely worried about (at least compared to, say, 2012), and the huge shift to everything online (followed by the AI bubble from early last year). This was the story of 2023, and why we saw bonds stay low (interest rates kept being higher for longer), while equities kept pushing up. In 2024 it might continue.

This sets us up for two major trends:

1. Big Tech keeps (and will keep) dominating

2. We have to get used to a higher neutral rate of interest

Before we jump into those two trends, just one question: what kept equities so much more attractive than bonds over 2023 and 2024?

Probably the economy. The recession never happened. It still might, of course, but given the resilient numbers we keep getting from GDP growth, from unemployment, and many other economic indicators, avoiding the recession keeps being incredibly bullish for equities.

This makes perfect sense - companies’ valuations depend on earnings. If GDP growth is 2, 3, 4% per quarter, this means firms are making money and growing. Better earnings impact valuations and their stock prices keep pushing higher. Then you get the momentum (FOMO) rolling, and TINA (there is no alternative), and soon a reinforcing cycle that keeps pushing everything up, despite all the headwinds and the open risks.

Macro conditions versus Big Tech

Which brings us to the most important contributor to all this: Big Tech. Or Mag7, whichever you prefer.