Market Update

The S&P 500 rose 2.5% to finish at 4070.56. We wrote two weeks ago that, “the next few days are critical to the S&P's near-term direction. A close above the (trading channel) resistance line in the coming week means a run to 4,100. Failure to break above over the next few trading days likely means a fall to 3,800.” The S&P did close above the resistance line last week and is now making its run to 4,100.

The S&P also has closed above its 200-day moving average six trading days in a row. The 200-day moving average is considered the long-term trend by technical analysts. It is still descending but is close to turning up. Price climbing above a flattening 200-day moving average is an important technical development. The S&P ‘s move above the trading channel resistance line was also a major accomplishment. That declining channel began with the all-time high of 4818.62 set on January 4th 2022.

We pointed out resistance in the 4015-area last week. The S&P broke decisively above the 4015-resistance area on Thursday after closing at 4019.81 Monday, 4016.95 Tuesday, and 4016.22 Wednesday. Climbing above the 200-day, the trading channel resistance line and the 4015 resistance area points to more upside. It clears the way for the index to take a run to 4,100 early this week. The index peaked at 4100.51 on December 1st. It hit 4,100.96 on December 13th. Its high Friday was 4,094.21. We should get a test of that high early in the week along with a test of 4,100. The S&P’s next major price target is the August 16th high at 4,325.28.

But to take out 4,325.28 will require continued positive news. The Federal Reserve meets this week. It will raise the fed funds rate by 0.25%. Investors expect it to raise the funds rate by another 0.25% in March. The Fed funds futures market is currently indicating that the March rate hike will be the last. The Fed’s guidance at the Wednesday press conference will have investors on pins and needles. Investors are hoping it will show its hand and confirm that the March rate hike will indeed be its last.

Earnings news needs to remain benign as well if the market is to continue higher. The 2023 estimates continue to fall. Analysts’ consensus estimate for 2023 S&P earnings is now $227.19, a 3.6% increase. Norwood Economics is expecting negative earnings growth in 2023. Negative earnings growth is not priced into the market.

Weaker than expected earnings will limit the market’s upside in the coming quarters. Climbing above the 4,325.28 August 16th high will likely take a trifecta of positive news. Inflation needs to keep falling. The Fed needs to signal they are done hiking after two more hikes. Earnings must grow in 2023. It is the last condition that is least likely to occur. The S&P 500 may rally for a while longer, but the upside is limited. The risk is skewed to the downside given the likelihood of a recession by year-end.

Economic Indicators

Economic data continues to trend weaker. The Conference Board’s leading economic indicators index (LEI) fell again in December. It declined 1.0% after falling 1.1% in November. The LEI is a gauge of 10 indicators designed to show whether the economy is getting better or worse. It was the 10th decline in a row. The rate of decline is increasing. The index is down 4.2% over the last six months. It fell 1.9% in the previous six-month period. There was widespread weakness among the leading indicators in December. The labor market conditions leading indicator worsened. Manufacturing, housing construction, and financial markets indicators also showed weakness.

The coincident indicators index has not weakened yet. Current strong employment and personal income numbers are keeping it from falling. The Chicago Fed national activity index (CFNAI) was negative 0.49 in December. The CFNAI was negative 0.51 in November. The CFNAI is made up of 85 different indicators. A negative number indicates that the economy is growing below trend.

The S&P U.S. manufacturing PMI was 46.8 in January up from 46.2 in December. The services PMI was 46.6 versus 44.7. Numbers below 50 show contraction. Real final sales to domestic purchasers climbed 0.8% in Q4 down from 1.5% growth the prior quarter. Fourth quarter GDP was a stronger than expected 2.9%. Durable goods orders rose 5.6% in December after falling 1.7% in November. But new orders for nondefense capital goods excluding aircraft decreased by 0.2%. Nondefense capital goods excluding aircraft is a proxy for business investment.

The jobs market remains strong. Initial jobless claims were 186,000 down from 192,000 the prior week. The payroll number comes out this Friday. It could move the market, which way is the question. Monday’s Q4 employment cost index release may also lead to market volatility. The Fed has made it clear it is focused on the jobs market and wage growth. It wants to see the jobs market weaken and wage growth slow. Norwood Economics does not expect the Fed to cut rates until both of those conditions are met.

Stealth Indexing at Its Finest

Financial advisors charge a fee to manage a client’s investment portfolio. There are three levels of portfolio management. Strategic allocation is deciding on a long-term asset allocation. An investor's strategic allocation shouldn't change very often. Tactical allocation is changing your asset allocation because an asset class is cheap or expensive. It's a one-to-two-year view on an asset class or subclass. A portfolio manager may overweight one asset class believing it is cheap. They would be underweighting another asset class by necessity. The last level of investing is security selection. Picking individual stocks, bonds, and mutual funds that will outperform.

Stocks, bonds, real estate, and commodities are the four broad asset classes. Some advisors might include private equity and hedge funds as well. The last two aren’t asset classes though. Private equity is an equity investment. Stocks are an equity investment. Likewise, hedge funds aren’t an asset class. They are investment vehicles that employ various investing strategies.

Most financial advisors only help with strategic allocation. They don't make tactical allocation calls. Norwood Economics has been underweight bonds since March of 2020. We only recently started increasing our bond exposure back to normal weights. There was no value in owning bonds when the entire yield curve fell below 1% in March of 2020. It was an obvious underweight. Our clients benefited from the underweight in bonds during 2022.



Nor do most advisors try to pick stocks, bonds, and mutual funds that will add excess risk-adjusted return (of course they tell you they do). Instead, they build stealth index portfolios. An index portfolio is composed of index funds. A stealth portfolio is constructed to mimic the markets. It is intended to give the appearance of active management but without the hope of earning excess returns.

The best way to illustrate a stealth index portfolio is to give an example. We looked at a prospect’s portfolio a few weeks ago. Here's what we found:

The portfolio has 132 positions. It has 116 stocks and 16 mutual funds. There were eight bond mutual funds and eight stock mutual funds. The stock mutual funds held anywhere from 61 to 373 stocks.

It only takes 15-25 stocks to achieve 90% of the benefits of diversification. You can completely diversify a stock portfolio with 40 positions. We are talking about company-specific risk. Diversifying away the idiosyncratic risk that accompanies an ownership stake in a company. We are not talking about systematic risk. Systematic risk is hard to avoid and can’t be diversified away. Systematic risks include economic, geopolitical, and financial factors such as interest rates.

You own the market when you own 116 stocks and eight stock mutual funds. Owning the market means earning the market return minus the fees and expenses. You are better off owning the market through low-cost index funds. Why pay a financial advisor to (stealth) index for you?

There are additional costs to the stealth index approach besides the fees. Knowing what you own and how much you own are the basics of investing. It’s difficult to know 116 companies well. It's known as information drag. Warren Buffet understands the importance of knowing what you own. It’s why he has so few stock positions.

As well, owning too many mutual funds can lead to overlapping investments. Not too long ago we reviewed a portfolio that had 125 holdings, many of them mutual funds. Microsoft and Apple were owned by 12 of the mutual funds. The twelve mutual funds were basically the same investment. The appearance of diversification without diversification. The prospect had far more exposure to Microsoft, Apple, Alphabet, Tesla, Nvidia, Amazon, Netflix and the other market favorites than they realized. It didn’t work out well for them in 2022 since those were the same stocks that were clobbered as interest rates rose.

You are far better off indexing than owning a stealth index portfolio. You will outperform the stealth index portfolio due to lower costs. You will also know what you own and how much you own. In other words, better risk management. You should fire your financial advisor. They’re charging you an active management fee with little or no active management.

Norwood Economics is an active money manager. Our clients own around 20 stocks at any given time. We use index ETFs for fixed income, emerging market equity, and real estate exposure. There is no overlap in our holdings. We know what we own. We know why we own it. The portfolio cost is less than 0.10%. Norwood Economics is an active manager. We make every effort to earn our fees.

Regards,

Christopher R Norwood, CFA

Chief Market Strategist