QQQ - SPY: 3 Reasons Not To Believe In This Rally

2023-11-13 13:50:58 ET

Summary

• The SPDR® S&P 500 ETF Trust and NASDAQ have rebounded strongly over the past two weeks after dismal performances in August, September, and most of October.
• However, there are several reasons to believe this recent rally in equities is likely to be short-lived.
• Among these are the lack of breadth of the advance, slowing global economies and the deterioration in the outlook for the American consumer and commercial real estate.

A great reason why a gloomy history may repeat itself is that we may have neglected what history did. When we neglect what history did, history visits us in the same cloth ” ? Ernest Agyemang Yeboah.

Equities followed up on their best weekly performance since late 2022, with gains in four of five sessions in the week concluded on Friday, November 10th.

For the week, the SPDR® S&P 500 ETF Trust (SPY) advanced by 1.31%. Technology was easily the best gainer among the 11 sectors within the index with better than a 4.7% rise on the week. Energy lost nearly four percent on the week on the drop in crude prices (CL1:COM), while both Utilities and Real Estate lost more than two percent during the week on the rise in interest rates. The small cap Russell 2000 (RTY) was off by three percent on the week. It was biggest weekly divergence between the Russell 2000 and the S&P 500 (SP500) since March of 2021.

It has been a much-welcomed two-week respite for investors after dismal market performance in August, September, and through most of October. However, there are several key reasons to believe this rally is not sustainable and will soon fade.

There Is No Breadth:

One of the biggest " tells" about the weakness of the overall rally is the lack of breadth in the advance. This has been a theme throughout 2023 as the market is more " top heavy" than at any time in recent memory. Something borne out by the chart below.

Almost the entire advance in equities this year has been driven by the largest 10 stocks by market capitalization. Take out the contribution of the "Magnificent Seven" and the just over 16% return for the S&P 500 (including dividends) in 2023 becomes slightly negative for the year. This put this collection of " Indians" in the same company as the Russell 2000, which is also slightly down this year while the NASDAQ (COMP.IND) has risen by just over 43% as of Friday's close.

This lack of breadth reminds me of the market action at the tail end of the Internet Boom before the inevitable bust. For older investors, it might bring back memories of the rise and demise of the Nifty Fifty . Unless the rally develops significantly more breadth, it is hard to believe the rebound will be sustainable.

Growth Is Slowing:

The rally over the past two weeks hasn't changed the growth dynamics, or lack thereof, in the economy. The 4.9% GDP growth estimate for the third quarter of this year should be treated as a one off. A good portion of which was driven by huge amounts of government largess via such channels as the Inflation Reduction Act. These are non-sustainable growth drivers especially given the massive and fast-growing national debt, which was one key reason Moody's just changed their outlook on the Aaa credit rating of the U.S. from stable to negative.

The latest GDPNow estimate from the Atlanta Fed has 2.1% GDP growth penciled in for Q4. This is significantly above most economists, it should be noted, that see flattish growth to end the year. Job growth is also falling noticeably with full-time position being lost over the past three months while part-time jobs surged. Eight of the first nine monthly BLS jobs reports in 2023 have also subsequently being revised down.

Nor can the U.S. expect much help from the rest of the globe when it comes to growth. Our largest trading partner, Canada, has had two straight quarters of declining or flat GDP growth. China is seeing falling exports on weak global demand, emerging deflationary pressures , and an imploding property market .

Meanwhile in Europe, GDP fell slightly in the third quarter and the continent seems on the verge of a mild recession. Japan also is facing economic problems on multiple fronts. The lack of global growth prospects and demand is one reason crude oil prices have fallen lately despite the situation in Gaza that could trigger a wider regional conflict.

The Coming CRE Debacle:

There are many geopolitical concerns that could escalate which could trigger a significant sell-off in the markets. These range from a collapse on the Ukrainian front after that country's recent offensive failed to the situation in Gaza drawing in other players in the region like Iran and potentially closing the Straits of Hormuz. China invading Taiwan is a much-discussed potential Black Swan that also has a very low probability of happening but would trigger a massive disruption to the markets as well as to the global economy.

However, the most likely thing besides the deterioration in the health of the American consumer that triggers a recession is the accelerating crisis in the commercial real estate or CRE market. As I have noted several times, default rates have been rising sharply here in 2023 across most CRE categories. The volume of Commercial Mortgage-Backed Securities or CMBS loans that were classified as delinquent at the end of the third quarter increased by over 40% percent during the nine months through September, to $26.56 billion. The delinquency rates moved from 3.03% at the start of the year to 4.4% at the end of Q3.

One only has to read through the recently issued third quarter CRE report from Trepp to realize the situation is on its ways to getting much worse as we head to 2024. As you see below, approximately $540 billion of CRE debt has to be rolled over at much higher rates next year. Of which, just over half is held by banks, mostly regionals.

Investors should look for delinquency and default rates to continue to increase in the coming year. The recent bankruptcy of WeWork Inc. (WEWKQ) will just aggravate this situation given the company was the largest leaseholder in the country with some 20 million square feet of office space. WeWork is now in the process of terminating many of those leases, which will have their own ramifications as I addressed in this recent article .

This, in turn, will continue to increase the stress in the regional banking system, which already saw the second, third and fourth largest banking failures in U.S. history during the first half of the year. Regional banks generate approximately 70% of CRE loans and hold some 30% of overall CRE debt on their books. It isn't hard to see a scenario where a " credit crunch" develops as the result of a collapsing CRE market in 2024, pushing the country into a recession.

Verdict:

With S&P 500 trailing at more than 20 times trailing earnings and the 10-Year treasury yield at over 4.65%, there is little to no " risk premium" in the market at current trading levels. In addition, the S&P 500 has now had over 10 failed attempts to meaningfully break through resistance around the 4,400 level.

It is for the reasons above that I believe the rebound in the markets over the past two weeks is likely to be short-lived. Towards that end, on Friday I increased my short position against the SPDR® S&P 500 ETF Trust via long dated, out of the money bear put spreads .

The worst part of being very well-prepared for a disaster is this: Now you start wanting that disaster to happen! ”? Mehmet Murat ildan.

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