This trend is not your friend

Risk remains high for a reversal

To say May was a tale of two markets doesn’t fully paint the picture of just how wide the divergence in returns was for the month. As AI hype fueled the mega-cap tech stocks higher, the rest of the market languished over concerns about the strength of the economy and banking system. For investors, the determining factor on whether you are enjoying this year is whether you had a weighting in these few winners.

The spread in performance year to date between the S&P 500 market cap-weighted and equal-weighted indices is the most on record, showing how narrow this market has been. This isn’t what is normally viewed as a healthy market. In most years with positive returns, investors would like to see broad sector participation. That is not the case today, which causes investors to ask if the spread between winners and losers will be resolved by the winners pulling back or the laggards rallying to catch up.

The last time most investors remember a market with a lack of breadth similar to this was in the early 2000s during the dot.com craze. That market resolved the spread by a collapse in the leaders and kicked off a multi-year bull market for the previously lagging cyclical sectors. Will history repeat these trends?

Parallels between the dot.com boom and today can be seen in many areas, with the obvious being the hype around a new world-changing technology. Whether AI will be a world-changing development like the internet and e-commerce is too soon to tell. The early results are promising, but it is also in the very early stages and like the early days of the internet, not all the early winners will be there in the end.

Outside of technology, during the month, investors were also faced with the risk of a U.S. debt downgrade resulting from a failed process. That process thankfully appears to have concluded in a deal at the last moment to avert disaster, yet provided another reason for many to remain on the sidelines or defensively positioned. With that risk now off the table, attention will return to the central bankers and their battle with inflation.

The fastest interest rate tightening cycle in history has succeeded in cutting inflation in half from its peak of last summer, yet remains much higher than the target. One risk emerging in the bond market revolves around rate-cutting expectations. Investors have gotten too comfortable with their assumption that both the Canadian and American central banks are either done hiking rates or getting ready for a pause. With each data point around strong employment and higher inflation, this narrative is becoming harder to believe. With a resilient economy and persistent inflation, central bankers will be hard-pressed to remove their hawkish stance, which is contrary to current expectations and may lead to a negative surprise.

Good news already priced in?

An emerging concern is that all the potential good news is now priced into the market. Despite the recent technology rally, equities have essentially moved sideways and been stuck in a narrow range for most of the last year. As we entered the year, fears centred around a recession, earnings collapse, and central bank policy error. With strong macro data, fears of a recession have faded in the past few months. Earnings for the first quarter reported were better than feared, and in recent speeches, U.S. central bankers have signalled a pause. If the narrative from the bankers changes, many may also begin to question what other misplaced beliefs exist.

For the balance of the year, plenty of risks remain in equities and fixed income. Complacency has taken hold for many as the market has “climbed the wall of worry.” But this isn’t the time to chase hot trends and accept everything is perfect. Thin summer markets can be volatile, and with only a few names holding things up, the risk remains high for a reversal. Cash remains an attractive hiding place for many and has the potential to fuel a rally once it comes off the sidelines. But at this point, the risk-reward is not attractive to chase the winner, and prudence would suggest that those looking to increase exposure stay defensive with the cyclicals in anticipation of a mean reversion trade.

Greg Taylor, CFA, is the Chief Investment Officer of Purpose Investments Inc.

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