Sizing up the pullback: "You are here"
The main thing we are seeing is a shift in the dominant psychology around the market. I have done this long enough to know that valuations matter in bear markets. In bull markets, there's a narrative that obviates the influence of stable valuation measures. Generally, in a strong bull trend, something has changed, and that change causes standard valuation methods to be chained to the prior reality, and the prior reality has little sway over the new reality, which is focused on something around the corner that changes the game. In the current case, the around the corner narrative that changes the game is about the increased productivity that springs from emerging AI technology solutions. But it isn"t just about the companies producing such technologies or even just about their suppliers. It's also about the companies that will see augmented profitability simply through access to such technologies. Standard valuation methods can"t capture a dynamic like that in real time. It"s not possible. But markets go about their business of trying to price such a dynamic in even if it stands to completely reshape the economic environment at a scale never seen before. We have been through it several times, in a relative sense. When we transitioned from steam engines, horse-and-carriage town transportation, whale-oil lamps, and the telegraph to gas-powered motors, automobiles, electrification of whole regions, and the telephone system in the 1920"s. When we transitioned from TVs, landline telephones, and a real-time information ecosystem to computers, a global fiber-optic infrastructure, and on-demand content in the 1990"s. Certainly, there have been other similar defining shifts in the past. . But the current transition—the "age of transformation"—stands to be the most dramatic, and the most rapid, of them all. As markets come to terms with this reality, we will see multiple dramatic attempts to price in the power of that proposition, and we will likely also see plenty of moments of doubt along the way: some sharp; others mild. That said... In the past few months, the market has witnessed high levels of risk acceptance from both retail and professional investors. This phenomenon has contributed to the market's vulnerability to negative news, as fund managers reduced their cash allocations to a low of 4.2% according to Bank of America"s most recent Fund Manager Survey. Futures and options data agree: the market's fast money had become heavily committed as of the recent highs, making it more susceptible to significant downside movement in the event of unfavorable news. During market pullbacks, it is essential to recognize the thresholds of investor pain. When we witness a sharp decline in the market over two or three consecutive days, it often signals distress among investors who entered the market near recent highs. These investors face potential margin calls, which can significantly impact their portfolios. One recent example of this can be seen in SMCI, a company that failed to pre-announce its earnings last week, instead merely scheduling its earnings release with no guidance, a move that led to concerns among investors about the entire AI space. The last time SMCI chose this approach (and the only other time in the company"s last 8 quarters that it did so), it reported lackluster earnings, adding to the caution surrounding the company and its peers. The selloff that followed this recent event (last Thursday) was particularly pronounced in large-cap tech stocks, with the AI-related sector taking a significant hit. Notable losses were observed in companies like ARM and NVDA, among others. It is worth noting, however, that the Dow closed the day on Friday of last week in positive territory, indicating that the panic was not widespread but targeted to specific sectors and companies. This selloff appears to have been driven by margin calls on retail investors who had heavily invested in top AI names. NVDA, in particular, seemed to be a significant target for this selling pressure. As market participants shift their focus to the next catalyst, the upcoming earnings season takes center stage. In light of recent events, it is essential for investors to assess the risks and rewards associated with their portfolios. The recent market action has highlighted the importance of understanding investor pain thresholds and the potential impact of margin calls. As the market moves forward, it is imperative for investors to closely monitor their holdings, particularly in high-risk, high-reward sectors like AI, and adjust their strategies accordingly. Geopolitics and the Market Whenever geopolitics enters the equation during a period when the market is trading above an upward-sloped 200-day moving average, it's usually a buying opportunity in some form. This lesson holds true for at least the past seven decades: geopolitical hurdles never mark a major market top. But that doesn't mean it can't happen. In other words, the type of characteristics that typically mark tops in the stock market when it is in full bull market mode—things like record low put buying, record low portfolio manager cash allocation, record low dividends relative to interest rates, etc—could be in place at the same time as we see a major geopolitical catalyst (as we did in 1915 at the outbreak of the first World War). But, typically, that's a difficult coincidence to imagine. As it turns out, right now, we see balanced put/call buying, balanced dividend rates relative to interest rates, and historically average portfolio manager cash allocation. We do see shorter-term sentiment and positioning data points that have recently reached extremes, and some worries around junk bonds. But none of these measures fall into anything approaching a historically extreme reading. The tit-for-tat strikes between Israel and Iran may have concluded with Israel's attack last week, leaving a hammer "doji" candlestick at the $5000 psych level in the S&P 500 futures, presenting a potential bottom in a 5% corrective swing. Given the larger trend in place (see weekly chart below), bears will need quite the coincidence to mark a major long-term top at this point. As such, the more obvious bet—especially given the build-out in breadth in the market to include materials, energies, and industrials—is to look for long-side opportunities in areas other than the Magnificent Seven (AAPL, AMZN, GOOG, NVDA, MSFT, META, & TSLA) and other than hard-core AI plays (ARM, NVDA, SMCI, etc). Overall View We are far from "perma-bullish" here at AInvest. We measure each day as it presents itself, fully bearing the knowledge that markets can reprice in either direction. And we have no qualms about seizing opportunities on the short side of the market. As we see it, the market at its recent highs was more vulnerable to bad news than to good news for reasons involving both retail and professional money manager sentiment and positioning. And, at that point, it got its fair share of bad news—with something approximating full-blown war possibly involving a nuclear power state and also the Federal Reserve breaking with its recent language and clearly pivoting toward a new level of hawkishness. We don"t deny these factors. However, the geopolitical factor may already be resolved enough to allow the market to become once again defended by deep-pocketed managers. And the Fed"s shift was highlighted by Powell"s explicit statement that the shift was due to growth resilience rather than stagflationary conditions and that it has no plans whatsoever to resume a process of further hikes. Productivity has been the main factor buoying rates. Not stagflation. Most are now looking for no recession this year. Hence, higher rates are a result of a more robust growth outlook. True: a handful of hot retail AI stocks got way ahead of themselves. But most industries and sectors have been playing catch-up over the past two months in the context of an upward trending market accompanied by stronger-than-expected growth on a broad economic basis. The rate story is not independent of the growth story. Might we see some more downside in this correction? Naturally. The 200-day moving averages haven"t even been brought into play. As always, approach the market as if you are picking up a rattlesnake. Care and caution and a viable exit strategy are always preferable to a bite. But probabilities matter. Given the foundation of this bullish trend, history leans toward cautious buying into the bloodletting. All of this said, if Friday"s PCE data input indicates a further intensification of inflationary pressure, we would seek out lower prices for new share interest.