Ketu Desai
By Ketu Desai
While the Fed skipped a rate hike in June, that is the message they are sending. Higher for longer. The Fed said that it expects to raise rates two more times this cycle, bringing Fed Funds north of 5.5 percent. The Fed expects to keep rates at that level well into 2024. Despite the aggressive tightening cycle, there are indications that one of the most rate sensitive sectors, housing, is bottoming and might accelerate. Housing starts rose an astonishing 21.7 percent in May, with units rising the most in three decades. Building permits were up 5.2 percent, a good leading indicator for future growth.
The NAHB crossed 50, indicating a favorable outlook. Housing has an important multiplier impact on the economy. Historically, each housing start creates four full-time jobs. Adding ~1.5 million in US starts per year is ~6 million additional jobs. Earnings and guidance from Toll Brothers and KB Home provide more evidence that housing is recovering. The KBH CEO said on the earnings call that, “as we discussed on our first quarter call, we have begun to see a sequential improvement in demand in February, which continued throughout our second quarter. As a result, we generated net orders of 3,936, significantly above our guidance.”
The combination of housing with the approximate $2 trillion in spending coming from the IRA and Infrastructure bill provides the economy with a nice cushion. This also means that it will be harder for inflation to hit the Fed’s 2 percent target. Meaning higher rates for longer.
Market internals are often the best economist. There are three groups that are early cycle tells, semiconductors, homebuilders, and transports. Homebuilders are at all-time highs. Semis are within striking distance of all-time highs. Transports started catching a bid during the month, up almost 10 percent, and near 52-week highs. Compare that with defensive sectors that could be a leading indicator of recession, healthcare, utilities, and staples. All three are down on the year. The rally has been narrowed, carried by a few large cap technology stocks. Market-cap weighted S&P has outperformed equal-weight by almost 10 percent YTD, a historic outperformance. However, in June we started seeing some breadth expansion with both equal-weight and small caps outperforming market-cap weighted S&P. If the breadth expansion continues, that is a great sign that the rally has legs.
We are in a momentum market. Quant funds, CTAs, and macro funds are in control of the market. They tend to emphasize technicals in their process. Many are trend-followers. The current trend is long large cap tech, long AI related names, long homebuilders, and in cyclicals long industrials. These are the sectors that have the highest expected earnings growth in 2024. Homebuilders have rallied because higher rates have reduced existing home supply creating a supply/demand imbalance. Secular trends in AI, infrastructure, national security, supply chain onshoring have kept a bid under semis, software, and industrials. While the large cap tech rally has been nearly all multiple expansion and they are expensive, trading at an average of 31x, they will likely continue to be bid up.
Money flowing back into the market and short covering will support these names. There is $5.5 trillion of cash on the sidelines and a trillion in shorts. As both groups change their positioning, this will support large cap tech. They will also sustain their bid behind AI excitement and flight to quality. In many ways, with rates higher, these companies will continue to serve as defensive, as they do not have balance sheet risk. Large cap tech borrows lower than the current Fed Funds rate. If we do get breadth expansion, the meaningful upside is in broader cyclicals and small caps than the current trend. Cyclicals and small caps are the cheapest areas of the market, with many subsectors trading at single digit earnings. Small and mid-caps trade at less than half the price of large cap tech, with sectors such as energy in the single digits. Positioning is way offsides in cyclicals.
By some measures the positioning in cyclicals is near pandemic lows. It will start with short covering on continued economic and earnings resiliency, as market internals suggest. As price moves above certain moving averages and resistance levels and moving averages start to inflect up, momentum players will start to pile in. As momentum players start to bid up the price, the people that missed the rally so far will come into cyclicals, as their cheap valuation and a higher for longer environment will justify positioning, driving a meaningful rally.
Looking forward, the market will focus on economic data, second quarter earnings, and Fed meeting.
Ketu Desai is the Principal of i-squared Wealth Management Inc. (www.isquaredwealth.com), an investment management firm based in New Jersey. [email protected]
