February 6, 2024
Three months of a relatively benign macro backdrop has resulted in low equity volatility and higher valuations, though narrow leadership is cause for concern. The SPX now trades at ~20x forward earnings, which is at the upper end of the historical averages. The equal-weight S&P 500 (SPW) trades at a more reasonable 15.5x forward earnings and the Russell 2000 (RTY) trades at a rare discount to the SPX of 18x.
Prior to today, the RTY’s biggest ever underperformance vs the SPX was during the 1990 recession when it underperformed by ~14.0% from peak to trough. This time around, the RTY has underperformed the SPX by ~21%. The RTY will eventually close the gap with the SPX once the yield curve begins to steepen. The 2/10 yield spread is now -30bp and we’d expect to see RTY begin to outperform when the spread narrows to -10bp or higher. This should also correspond with the RTY sustaining a break above 2040 (4.7% above current levels).
A bull market characterized by narrow leadership and performance concentration is unsustainable. Leadership from mega-cap Tech would be fine if other groups and sectors were participating, but they’re not – at least not currently. Markets are now fully priced for a soft landing, which increases the risk of a potential disappointment. The 2/10 curve remains deeply inverted and the current +4bp slope in the 5/10 curve isn’t signaling an imminent Fed pivot. We continue to look for the first cut to come in June, but that could also be pushed out if supply chain-driven prices slow the pace of disinflation. One-year real yields currently sit at +205bp, which is highly restrictive and increases the risk of something breaking. Rising equity volatility (VIX levels >20) would be your first clue.