The End of Inequality

With all the ink being spilled on what the year ahead might bring, I thought I'd focus my first piece of 2022 on where we've been already. The "market" that most of us talk about is, notionally, at all-time highs and optimism is growing as we start the year. But a nagging feeling has come over many investors who have lagged the advance. Many of their portfolios contain stocks that have corrected significantly despite the inexorable advance of the S&P 500 and other major averages. Apparently, not all stocks are created equal.

The chart below explains this conundrum. It is a depiction of the ratio of an 'equal weighted' index of the S&P 500 constituents relative to the 'market weighted' equivalent that we all know and love. What I have depicted is a potential trend line that needs to hold if the market is to generate broader participation and create a healthy advance. I spoke of the lack of breadth in the November bounce that led to the early December fade. The reemergence of the pandemic in late Q2 last year marked the 'top' for this ratio. Could we see this trend line hold in 2022?

S&P Equal Weight/Market Cap Weight Ratio

Another measure of the lack of participation since the re-opening trade peak last spring is the number of stocks above their 50 day moving average. At one point in late November, the market had more than 70% of its constituents in a short-term correction - below their 50 day moving average. That oversold condition is now behind us as the Santa Claus rally extends into the new year.

NYSE % Above 50 DMA

The 'buy the dip' mentality that has pervaded investor behaviour since the 2020 market bottom has been frustrating those looking for a significant market setback of greater than 10%. That explains the high cash balances in many portfolios, as the fears of Fed tightening and Omicron battered bullish sentiment in the last few months of 2021. This week we have seen a mesmerizing resurgence in Apple's stock price towards the $3tn market cap level. A narrow FOMO rally into the new year has reversed the poor close for the broader market in December that involved a brutal tax loss-driven and highly window-dressed finish to the year. The market now desperately needs to spread out to left behind segments. But I believe it will.

The many small-capitalization stocks that disappointed us last year are ripe for a rally. The chart below demonstrates the same pattern as the equal-weighted example above. If the economy re-accelerates in a post-pandemic re-opening 2.0, these left-for-dead stocks will catch up. I am predicting that lagging market segments can generate tons of alpha, post-Delta, and Omicron!

Russell 2000/1000 Ratio

The basic conditions of non-challenging financial conditions, rising earnings expectations, and renewed cyclical impulses in the global economy will continue to support risk-taking, despite rising bond yields. An orderly progression to a normal fixed income environment, while not assured, is my working hypothesis for now. The Fed, having learned its lesson in 2018, will continue to normalize policy, while staying 'behind the curve' of inflationary forces. This week's bond bust is just a reversal of the Omicron-driven risk-purge that drove fixed income yields down artificially in November. The biggest risk to stock prices is a disorderly rebalancing of portfolios that leads to a spike in 10 yr Treasury yields above 2%. So far the sell-off seems pretty benign.

Despite this seemingly pollyanna scenario, I do agree with those looking for heightened volatility. It comes with the territory, given the reversal of the excess liquidity made necessary by the pandemic. A 'traders market' for a change. It should be a fun 2022, - all things being equal.

Risk Model: 4/5 - Risk On

The Model is back in synch with the market after its recent flirtation with the bears. Reduced VXV volatility and a marginally positive Copper/Gold ratio have righted the ship. The AAII sentiment has recovered from the Q4 plunge despite the screaming headlines of Omicron case counts. Is it the resignation to the persistence of the pandemic or a looking-over-the-valley mentality? Either way, investors have seemingly inured themselves to any perceived economic effects of the Covid crisis and continue to chase short-term upward momentum in equities. But if the market is to be truly rewarding, we will need to see more days like today, in which the Dow and S&P outperform the NASDAQ.

Bitcoin

Crypto players seem to be sidelined in the short term as the rising yield environment and strengthening U.S. Dollar have them hemmed into a corner. The weakening technical pattern would argue for caution and a double top is a distinct possibility now that the hype of last year has died down. If the scenario of a re-rotation to cyclical and value stocks holds, the Bitcoin trade could also come to grief. It just looks like any other over-hyped growth stock to me now. A break of $45K would be interesting, to say the least.