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Good morning! In the second quarter, Netflix’s efforts to crack down on freeloaders resulted in nearly 6 million new sign-ups. However, even this impressive growth wasn’t enough to impress the market. The stock fell 8% after revenue missed expectations. Tesla experienced a similar story, with decent earnings growth overshadowed by squeezed margins, causing the stock to drop 5% after hours. Interestingly, these declines in two superstar stocks stand out against an overall positive market backdrop, which I will discuss further below. Please feel free to reach out to us at [email protected] and [email protected].
Risk-on mode is in full swing! In recent weeks, investor sentiment towards the 2023 rally has undergone a substantial shift from disdain to admiration. Waves of positive economic news have transformed an initially unpopular and narrow bear market rally into a broad-based rally supported by strong sentiment.
The encouraging inflation report from last week is just one piece of the puzzle. Economic data has consistently exceeded expectations, as evidenced by the two-year high reached by the Citi Economic Surprise index, which historically indicates positive stock returns.
Aside from these omens, the undeniable fact is that the S&P 500 has already gained nearly 20% this year, and the foundation of this rally seems increasingly solid. What initially began as a concentrated bounce in the seven major tech stocks has now spread out since early June. The equal-weight S&P 500 has recently outperformed its market-weight counterpart, as shown in the chart below:
This widening participation in the rally coincides with a more positive sentiment surrounding it. The AAII survey of individual investors, which has remained negative since late 2021, has suddenly turned strongly positive. The following chart depicts the percentage of investors feeling bullish minus those feeling bearish, based on a four-week rolling average:
Back in mid-May, when the market was stagnant, the only consistent sources of equity demand came from corporate buybacks and algorithms. However, that has changed. Discretionary investors have reentered the arena, according to Deutsche Bank’s Parag Thatte, Binky Chadha, and Karthik Prabhu. In a recent note, they highlighted how discretionary participation in the past month has reached levels comparable to those seen after the vaccine announcement in late 2020 and the 2016 presidential election. Various indicators they track, including hedge fund market exposure, options market pricing, and retail investor activity, suggest that investors are currently positioned with the highest level of aggression since early 2022.
One remarkable turnaround in sentiment can be seen in the regional banks that faced significant setbacks with the failures of Silicon Valley Bank and First Republic. Western Alliance, Comerica, KeyBank, and Zions, which drew negative attention in March due to large securities losses or concentration of uninsured deposits, have all rallied by 25% or more since the first week of July.
Meme stocks and speculative tech are also enjoying their time in the spotlight. Since June, the Roundhill Meme and Ark Innovation ETFs have seen gains of 35% and 25% respectively. Several of the stocks in the meme-stock fund are directly tied to cryptocurrency, which has experienced a bounce this year.
Interestingly, while equities are thriving, the Treasury market is showing a different story. Although ten-year yields briefly rose above 4% at the start of July, that widely-discussed move has now fully reverted. Yields are currently trading around pre-SVB levels. As we noted in our previous newsletter, the bond market may be waiting for clearer signals before making significant moves.
However, despite the calmness in the Treasury market, financial conditions in other areas are significantly more relaxed. Corporate credit spreads are narrowing, the dollar is weakening, and stocks are rallying, all while equity and bond volatility indices remain low. In fact, the Chicago Federal Reserve’s national financial conditions index is at its loosest level since early 2022.
The strong performance of asset prices will inevitably translate into increased consumer demand. The University of Michigan’s consumer sentiment survey from last Friday already hinted at this. The preliminary July numbers showed a significant monthly gain in consumer confidence, reaching a two-year high. However, as strategist David Rosenberg points out, the surge in consumer finances is primarily driven by the appreciation of assets. Only 3% of respondents attributed their optimism to rising wages, whereas 27% mentioned rising asset prices. This represents a doubling in the proportion of respondents who view their finances as better off due to rising asset prices in the past two months. Moreover, the probability of higher stock prices a year from now rose to its highest level since April 2022, reaching 55.1%.
While investors are jubilant about the rally, the Federal Reserve has no choice but to remain cautious due to the potential resurgence of inflation and its own hawkish stance. It is increasingly likely that the post-Covid inflation burst was initially driven by supply shocks rather than excess demand. However, inflation has since become embedded in demand, and loose financial conditions and euphoric sentiment could contribute to its persistence. The Federal Reserve finds itself in a challenging position, as investors revel in the rally.
This combination of rising risk appetite and the threat of inflation and a hawkish Federal Reserve sets the stage for an interesting remainder of the second-quarter earnings season. As expensive and beloved stocks such as Tesla and Netflix reveal imperfect results, we will discover the true depth of positive sentiment. (Wu & Armstrong)
If you’re looking for some interesting reads, check out Danny Leigh’s reviews of Barbie and Oppenheimer.
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