With Bull Markets Averaging 5 Years, the Best is Yet to Come – Unless...

On Wednesday, 15 May, all three major US stock indices (Dow, S&P 500, and Nasdaq) closed at new all-time highs. The week concluded with the Dow closing above the 40,000 milestone for the first time ever. This marks a remarkable journey, considering the Dow closed below 20,000 in March 2020.

Meanwhile, the Nasdaq experienced significant lows in autumn 2022, dipping below 10,500 in late September and early October. From October 2022 until Friday, 17 May 2024, the Nasdaq advanced by 45%, demonstrating a robust recovery. The Nasdaq 100 rose by 50% over the same period, reflecting the strong performance of the largest technology and growth stocks in the index.

A negative divergence?

The Dow Jones Transportation Average (DJT) closed at 16,500 on 17 May 2024. Comparing the DJT with the Dow Jones Industrial Average (DJIA) reveals a potential negative divergence, as the DJT has not kept pace with the DJIA's record-breaking performance.

According to Dow Theory, a negative divergence between the Dow Jones Transportation Average (DJT) and the Dow Jones Industrial Average (DJIA) occurs when these two averages move in opposite directions. Specifically, a negative divergence happens when the DJIA reaches new highs, but the DJT fails to confirm these highs and instead moves lower or remains stagnant.

In Dow Theory, such a divergence is seen as a warning signal that the overall market trend may be weakening. The rationale is that the transportation sector (represented by the DJT) should confirm the strength of the industrial sector (represented by the DJIA). If industrial companies are doing well and their stocks are rising, it is expected that transportation companies, which are integral in shipping and logistics, should also be performing well. Therefore, a lack of confirmation from the DJT suggests potential underlying weakness in the market that could eventually lead to a market downturn.

The Dow Theory was developed more than 100 years ago, and transportation stocks may not substantially impact the performance of Nasdaq tech stocks. Therefore, I like to replace the classic Dow Theory by spotting positive and negative divergences between semiconductors (taking the role of the DJT) and the Nasdaq or Nasdaq 100 indices. I like using the VanEck Semiconductor ETF (SMH) for semiconductor stocks.

Another negative divergence

The SMH ETF has yet to confirm the new highs seen in the Nasdaq and Nasdaq 100 this week. While the SMH has risen by 55% since October 2022, it fell short of making new all-time highs this week. This lack of confirmation from the semiconductor sector, which is typically a key driver of technology indices, could suggest potential vulnerabilities or a slowing momentum within the sector despite the broader market's strength.

Additionally, different FAANG-related indices and ETFs tracking the performance of major tech giants like Facebook (Meta), Apple, Amazon, Netflix, and Google (Alphabet) yielded different results. While some, such as the equal-weighted NYSE FANG+, yielded new highs this week, others did not. While the FAANGs and related megacap tech stocks have outperformed the markets since October 2022, they have largely failed to do so since early spring 2024. This (potentially developing) divergence could indicate that the largest tech stocks are not fully participating in the broader market rally, raising concerns about the sustainability of the recent highs in the major indices.

Additionally, the latest global Fund Manager Survey revealed the most bullish sentiment since November 2021, resulting in fund managers being the most overweight in stocks since January 2022. This may be too optimistic and could also signal a top.

On the positive side

Over 80% of S&P 500 stocks are now trading above their 200-day moving average, nearing the highest level since September 2021. Stocks continue to trend upward, with market breadth expanding. Financials, materials, and industrials are showing increasing strength, broadening sector participation. Inflation has stabilized, and the 10-year Treasury yield is declining. Rate hikes have ceased, and the Federal Reserve has signaled that their next move will likely be a rate cut rather than an increase.

As Ryan Detrick notes, bull markets often last longer than expected. This current bull market is only 19 months old, so it is still in its early stages. Historically, the previous 12 bull markets have averaged more than five years in duration. According to Jurrien Timmer, this bull market, which has risen 49% from the October 2022 low, aligns with the historical average performance of bull markets so far.

"I don't want to invest at all-time highs." I hear that a lot. But actually, you should! The most bullish signal a market can give is to keep going up. Investing at all-time highs can be a great opportunity. The chart below illustrates the point.

The macro picture

Last month, headline and core CPI, excluding shelter, increased by 2.2% and 2.1% year-over-year, respectively. This indicates that the PCED inflation rate is on track to reach the Fed's 2.0% target by the end of the year, provided that rent inflation continues to moderate. In April, both the rent of the primary residence and the owner's equivalent rent continued to show signs of disinflation.

The chart below highlights where inflation is occurring and where it isn't. Notably, the 12-month change in auto insurance remains the largest increase by far. Out of 29 components, 18 are at or below 2%. The main drivers of inflation are auto insurance, housing, restaurants, wages, personal care, and transportation.

What an outdated and misleading way to measure rent inflation!

Official inflation measures reflect a decline in market rents with a 10 to 12-month lag. The figure below shows the year-over-year growth in the personal consumption expenditures (PCE) index for rent versus the 12-month lead of two market rent indexes from Zillow and the Cleveland Fed. Over the past few years, several indexes have been created to provide more real-time analyses of rents. These indexes have been studied to see how changes in their measures correspond to changes in PCE or consumer price index (CPI) rents.

According to these studies, these real-time indexes tend to lead more traditional measures of inflation by about a year, as seen in the table below.

Improved data availability has allowed further analysis of how current rental market conditions (as captured by asking rents and newly contracted rents) influence official measures of shelter inflation.

For example, the 2022 working paper "The Coming Rise in Residential Inflation" explores the relationship between official residential inflation measures used in CPI and PCE and market rents as captured by the SFRI and ZORI. It finds that year-over-year growth rates in market rents have been accurate leading indicators for OER and rent inflation.

In particular, the year-over-year growth of OER inflation correlates most strongly with 12-month lags of private rents, while the year-over-year growth of rent inflation correlates most strongly with 13-month lags of private rents.

The authors also develop a forecasting model, predicting that OER inflation will peak in 2022 and remain elevated through 2023, with OER levels 5 percent higher on a year-over-year basis. They forecast rent inflation will be similarly elevated, ending 2023 at 6 percent year-over-year.

Such evidence suggests that the impact of the current slowdown in asking rents and newly contracted rents will manifest as slowing year-over-year growth of official rent price indexes over the course of next year. When will year-over-year growth in rent and OER return to pre-pandemic levels?

The Richmond FED conducted a simple forecasting exercise to answer this question using a vector autoregression (VAR) model containing year-over-year percentage changes in the PCE price indexes for rent and OER and the Cleveland Fed NTRR. Data are from the first quarter of 2005 through the third quarter of 2022. The Richmond FED used the estimated coefficients of the VAR model to iteratively generate forecasts for year-over-year rent price growth over a five-year forecast horizon.

The forecast for year-over-year growth in the PCE rent price index is shown in the figure below.

Between 2010 and 2019, year-over-year growth in PCE rent averaged 2.9 percent per year.

Based on current data and the estimated model, year-over-year growth of PCE rent will return to that pre-pandemic average in the third quarter of 2024.

The forecast for year-over-year growth in the PCE price index for OER is shown in the figure below. Between 2010 and 2019, year-over-year growth in the OER averaged 2.4 percent per year.

Based on current data and the estimated model, year-over-year growth of the PCE price index for OER will return to that pre-pandemic average in the fourth quarter of 2024.

The findings suggest that the shelter component of inflation will continue to impart upward pressure (relative to pre-pandemic norms) on the 12-month headline and core PCE inflation beyond the end of 2023.

Bottomline: We can expect declining shelter inflation to show up in the CPI and PCE from July to October 2024 onwards.

Next week may be crucial.

• Nvidia will be reporting quarterly earnings on 22 May. So far, Nvidia has not made new ATHs. I expect stellar earnings and guidance that tops analyst estimates.
• Microsoft will hold its developer conference (the Microsoft Woodstock event) to detail how successful (or not) copilot has been unveiling its vision for AI PCs. I expect positive surprises that may lead the shares materially higher.
• Apple will hold its big AI-focused Woodstock event in June 2024. I expect Apple to provide a comprehensive AI strategy similar to what the company did when Apple was late with 5G. I expect the shares to trade north of 200 USD after the event.

I would like to see Nvidia, Microsoft, Amazon, and Apple making new ATHs in the next four weeks to reinforce the AI-led bull. A failure to do so, alongside continuing negative divergences of various semiconductor indices versus the Nasdaq and Nasdaq 100 indices and the SP 500 Infotech sector, would be a warning signal for me.

Elliott Waves show nine waves up - this can signal troubles ahead.

The 3-year chart of the Nasdaq 100 below shows a significant rise with nine distinct waves since the bottom in autumn 2022. According to Elliott Wave Theory, this pattern meets the minimum requirement for a five-wave impulse structure with an extended third wave.

The current wave, labeled wave 9 (wave 5), might be the final upward move before reaching a significant top. If this interpretation is correct, we could soon be approaching a period of correction or consolidation. If we apply wave equality and expect the final wave 9 to travel the same distance as the first wave, we may have already reached the top or be very close!

I expect the bull to continue.

It is too early to tell whether this pattern will evolve. The negative divergences may have disappeared next week. There is no topping formation for the last wave in sight yet.

My preferred count is for the bull to advance much further. I agree with Ed Yardeni that we may even see a melt-up shortly, leading us to the level of 6.000 on the SP 500.

This would synch well with the target of 20500 to 21000 for the Nasdaq 100, which was my 2024 year-end target for the index and which I published in late 2023.

Any sign that shelter inflation is finally moderating in the official stats, solid earnings, and a resilient consumer may provide all needed for a final blowup top. Nvidia earnings will be a catalyst leading the market up or down substantially next week. In Jensen, the bulls trust!

2025 may be a crisis year for stocks. The first year of a presidential cycle is often the year of bitter pills to swallow. The US deficit clock is ticking at an unsustainable pace. Whatever the solution—higher taxes or less spending—the effects should be pretty damaging. The problem remains unsolved.

The deficit blob keeps growing.

The US federal deficit slightly narrowed to $1.63 trillion over the 12 months through April. However, during the same period, the US Treasury had to raise $2.63 trillion by issuing marketable securities, bringing the total to a record $26.9 trillion.

The Treasury had to borrow more than the deficit amount to replenish its checking account at the Fed, which had nearly depleted to zero last June. The debt burden continues to grow.

Meanwhile, the fastest-growing federal government expenditure is net interest paid on the debt, totaling $810 billion over the 12 months through April. This expenditure is set to soon surpass defense spending and is projected to reach $1.0 trillion before the end of this year.

Despite the surge in Treasury securities supply, bond yields are not soaring. Why? The Treasury has met most of its funding needs over the past 12 months through Treasury bills, issuing $1.92 trillion in bills compared to $653 billion in notes and bonds. Last year, money market mutual funds purchased $1.21 trillion of Treasury bills.

This cannot continue forever!