This article was originally published on Forbes on Oct 10, 2024,10:58pm EDT

The Fed surprised the market with an aggressive 50 bps cut recently, which has pushed the S&P 500 back to new all-time highs. However, not all markets are celebrating this move. Bond yields and mortgage rates, for example, have been in an uptrend since this decision, which is not normal to see at the onset of a rate cutting cycle.

Also, the bull market leaders – the Mag 7 and AI focused semiconductors – are making a series of lower highs, not confirming this move in the S&P 500. This divergence between the market leaders and the broad market has been the consistent theme of the I/O Fund’s broad market reports in 2024. More times than not, the bull market leaders will lead on the way up, as well on the way down. So, when my firm sees the primary beneficiaries of a bull market start to make lower highs while the broad market makes higher highs, it tends to be a warning.

In this report, my team will address the risks brewing in the market. The strange behavior in the bond market could be signaling that the FOMC has made a policy error. This coupled with key tech stocks trending lower against the S&P 500’s advance, has my firm cautious for the time being.

What Big Tech and AI Stocks Are Telling Us

In 2023 we saw these market leaders trending higher with the broad market. This was a powerful trend that lasted into late 2023. As a result, the collective Mag 7 returned around 90% in 2023 vs. the S&P 500 returning 24%. However, this trend is not continuing into 2024, as we are beginning to see cracks in market leadership.

This year, the Mag 7 are up ~30% compared to the S&P 500’s ~20%. Though this year has been excellent for investors, it’s concerning the relative strength between the bull market leaders and the broad market is narrowing, which has been a constant theme in our broad market analysis throughout all of 2024.

“When the cycle leaders start to underperform, it tends to mark the start of a trend change. The FAANGs have been the undoubted leaders of this bull run, and we are now seeing them start to trend lower against the indexes. More times than not, the leaders on the way up, tend to be the leaders on the way down.”

More importantly, the Mag 7 is making a lower high, while the S&P 500 makes a higher high. In other words, the bull market leaders are not confirming this push higher in the broad market. This is a rare pattern that has only shown up one other time in this bull market – July of 2023, just before we saw an almost 11% correction in the broad market.

A rare pattern observed in the bull market, similar to July 2023, preceding an 11% correction in the broad market. - I/O Fund

This divergence is not only happening with the Mag 7, but it’s also happening with the most important sub-sector within tech due to AI – semiconductors.

Since the current bull market began on October 13th of 2022, the Mag 7 has returned over 102% vs. the S&P 500’s 61%. During the same period, semiconductors have returned over 174%. The leading stock, Nvidia, is up over 967% over the same period. So, while the Mag 7 are the popular market leaders, the true market leaders of the current bull cycle are semiconductors, and specifically, Nvidia. This is a trend that the I/O Fund positioned for in 2022, making NVDA our largest position, as we rotated out of cloud stocks and into AI.

Performance of the Mag 7, S&P 500, and semiconductors since October 13, 2022: The Mag 7 returned over 102%, the S&P 500 returned 61%, and semiconductors returned over 174%, with Nvidia up over 967%. - I/O Fund

Semiconductor Index (SMH)

SMH has a history of leading market swings in the broad market. Since 2021, every time the S&P 500 made a new high without SMH, it preceded a period of volatility. Today’s divergence is one of the largest on record. The Semiconductor Index topped in July at $283, and is still well below this high, compared to the S&P 500 that just pushed to new a new high this week at 5796.

Chart illustrating the semiconductor sub-sector’s corrective pattern, featuring a 3-wave drop since June followed by a bounce from the August 5th low, suggesting a potential final drop targeting $190 to $165. - 123

When digging deeper into this key sub-sector, we can see that a clear corrective pattern is playing out. Since the June top, there is a clear 3 waves down. This has been followed, so far, by a symmetrical 3 wave bounce off the August 5th low. This pattern best fits a standard corrective patten. This implies that a final drop is still needed, which is targeting between $190 - $165.

The advance seen today is poking above the downtrend line from the July top. However, this is happening on less volume and less momentum. Note the momentum indicator below the chart. It has given three lower highs while price provided three higher highs. This is a rare pattern that tends to precede a trend reversal.

Chart depicting the current market advance above the July downtrend line, showing decreasing volume and momentum. The momentum indicator reveals three lower highs, while the price shows three higher highs, suggesting a potential trend reversal. - I/O Fund

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Nvidia (NVDA)

Nvidia topped in June at $140, and failed to make a new high in July with the rest of the Semiconductor Index. This was a warning that semis, and the broad market, were heading lower.

This same relative weakness is still present today. While most semiconductors have broken out above their August high, NVDA remained below it. This week, it has moved above the August high, which appears to be the final move in this bounce which is happening on less momentum and less volume. This lines up with the I/O Fund’s game plan, which was to sell a quarter of our NVDA position in June around $129, and attempt to buy it lower in the coming months, which was discussed in detail on my recent interview.

Chart illustrating NVDA’s incomplete corrective pattern, indicating potential drops below $114 and $108, which could lead to a decline toward the $90 - $70 region, completing a multi-month correction. - I/O Fund

Like SMH, NVDA appears to be tracing an incomplete corrective pattern. A move below $114 and then $108 will signal that the stock is heading toward the $90 - $70 region, which would complete this multi-month correction.

NVDA remains weaker than the broad market, as well as SMH. Considering the importance of this stock, as long as it remains below its June high, it is a warning to the current broad market advance.

Are New Leaders Developing?

Some have argued that the market is taking gains in the AI leaders and spreading that money out into beaten down sectors. In other words, there is a healthy broadening out of the market, which typically exhibits strength.

The narrative that supports this idea is that the FOMC just offered a surprise 50 bps rate cut into a seemingly healthy economy. The cheaper cost of borrowing should propel more economically sensitive sectors to play catch-up as the economic expansion continues.

As plausible as this sounds, it’s just not showing up in data, yet. Since the Fed cut rates on September 18th, we are not seeing money flowing into your beaten down sectors that should do well if this narrative is playing out.

Sectors like, transportation, small caps, retail sales, consumer discretionary and high beta are still under their 2021 highs. These are the sectors that would benefit from a soft-landing. As you can see below, aside from consumer discretionary, they are all underperforming the S&P 500.

Chart illustrating the market dynamics where AI leaders are gaining, but beaten down sectors like transportation, small caps, retail sales, consumer discretionary, and high beta are still lagging behind the S&P 500, showing no significant investment flow after the FOMC’s 50 bps rate cut. - I/O Fund

While Nvidia and Semiconductors are making a lower high, there is more money flowing into defensive and inflationary markets, like, Energy, Apple, Utilities and even the US dollar is doing better than the markets that would support the broadening out narrative.

What the Bond Market is Telling Us

Another unusual development since the Fed cut rates is that bonds are not acting as they should at the onset of a rate cutting cycle. Historically, the relationship between long-dated bonds and the Fed cutting rates has been an inverse relationship. As the Fed cuts rates, it is usually in the face of a weakening economy. If prices are going down due to demand collapsing, then a fixed yield is desirable in that environment, meaning that we should see bonds going higher.

This is not what is happening today. The day the Fed cut rates, the 10-year government bond began a sharp decline and is currently down nearly 4% from its high. This is a big move for the 10-year bond.

Chart showing the 10-year government bond’s sharp decline after the Fed’s rate cut, highlighting an unusual trend where bond prices typically rise in a weakening economy. The bond is down nearly 4% from its high. - I/O Fund

This is unusual behavior, as the above chart shows. Bonds should be going higher, not lower, based on historical comparisons. The popular narrative for this behavior in the bond market is that this is evidence that the FED accomplished a soft landing.

If we were going into a slowing economy, which could lead to a deflationary event, then bonds would be catching a bid. So, the fact that we are not must mean that the economy is strong, and the economic expansion will only continue. This will then propel asset prices higher, as well as inflation, making the need for fixed yields a poor investment.

As we just saw, the market is not buying this narrative, as money is not flowing into the sectors that would support this thesis. So, what could be going on?

It’s important to understand that the Fed does not control the 10-year yield; this is controlled by the bond market’s expectations for future growth and inflation. The Fed’s reasoning for aggressively dropping rates on September 18th was that inflation is heading to 2% and the employment market is starting to show weakness.

Since then, the ISM non-manufacturing PMI posted its hottest reading since February of 2023. Twelve out of the 18 segments of this report stated that prices are rising, not falling.

Chart highlighting the ISM non-manufacturing PMI’s highest reading since February 2023, with 12 of 18 segments reporting rising prices. Additionally, the labor market added 107,000 more jobs than expected, revising September figures up by 17,000, causing the unemployment rate to drop from 4.22% to 4.05%. - YCharts

This was accompanied with a labor market that is much stronger than expected. The most recent jobs report showed that the US added 107,000 more jobs than expected, while September’s report was revised higher by 17,000 jobs. This caused the unemployment rate to drop back to 4.05% from 4.22%.

This is further confirmed with current mortgage rates. Everyone was expecting mortgage rates to drop with the Fed Funds Rate. However, since the cut, there has been a sharp increase in average mortgage rate from 6% to 6.32%.

Current mortgage rates defy expectations, rising sharply from 6% to 6.32% following the Fed’s rate cut, contrary to the anticipated decrease. - YCharts

The reason for this is because mortgage rates are not determined by the Fed. Instead, they are the result of an equation that includes the 10-year yield and the borrower’s credit score. So, the 10-year getting sold, means yields are going up.

This happening on the day of the FED’s rate cut policy means the bond market is not convinced inflation is heading to 2%, which is pushing mortgage rates higher. This means that we could be getting signals that the FED made a policy error, and dropped rates too soon, as yields continue to climb in the weeks after this decision.

Interesting enough, at the Grant’s Annual Fall Conference, Druckenmiller stated that his largest bet is shorting the US bond market.

His reasoning is not because the Fed achieved a successful soft landing, which the consensus believes, but it is because “bipartisan fiscal recklessness is on the horizon.” In other words, the larger our deficits become, the more money will need to be borrowed to cover interest payments. As more and more debt gets created, yields will have to go up to attract more buyers, which will put pressure on fiscal budgets, and therefore creates a vicious cycle.

To put this into perspective, the budget deficit for the fiscal year 2024 is going to come in around $1.9 Trillion, or 6.7% of GDP. There is no other year in US history where the budget deficient was this large outside of a major war, like WW I & WW II, or dealing with a major recession, like 2008. It is unheard of to have fiscal spending this high, in an expanding economy, with historically low unemployment. This makes you wonder what the deficit will look like in the face of a contraction.

This was an issue that the market has been aware of for decades but was able to ignore due to historically low interest rates. With rates low and trending lower, this fiscal recklessness was allowed to go on. However, we are seeing for the first time in 30 years, bond yields are starting a new uptrend.

Since 1981, the 10-year yield has been in a classic downtrend, making a series of lower highs. This trend made borrowing easier, as low rates made the cost of borrowing affordable. However, in 2021, yields broke this downtrend and made their first higher highs in 30 years. Today, yields are higher than they were in 2008, making the cost of borrowing higher than most investors are used to in over 20 years.

Diagram illustrating the market’s awareness of excessive debt and low interest rates enabling fiscal recklessness. Since 1981, the 10-year yield has followed a downtrend until breaking the trend in 2021, resulting in the highest borrowing costs seen in over 20 years. - I/O Fund

If this uptrend in yields continues, which looks likely, it would become problematic for inflation expectations, as well as the Fed’s ability to lower rates. It will also become problematic for the cost to service government debts, as more debt will be issued at higher rates to cover current service requirements. And, it will become problematic for stocks, specifically high beta stocks that need to borrow to fund operations, as estimates on future cash flows will have to account for a higher cost to borrow. In short, the last +20 years have built on the idea that inflation will not happen, and the FED can keep rates close to zero.

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Broad Market Analysis

The bull market pattern off the 2022 low has taken the shape of a messy diagonal pattern. This is a 5 wave pattern where the internal waves are 3 waves in all directions. It is also marked with large, overlapping swings. Note how wave 4 went into wave 1 territory – this is typical of diagonals. The 5th wave in this pattern is a blow off, and from what I can tell, we are in the final swing of this pattern.

If SPX can breakout above 5825, then it can likely push into the 6000 – 6185 region. If instead, it breaks down below 5675 this will be your first indication of a potential trend change. Below 5500 and then 5115 will be the final confirmations.

Chart illustrating a messy diagonal pattern in the bull market since the 2022 low, consisting of 5 waves with overlapping swings. Key breakout points are at 5825, while downtrend confirmations are at 5675 and 5500, indicating potential trend changes. I/O Fund

In conclusion, as the economic expansion continues, the odds of a recession remain low. However, money is not flowing into the beaten down sectors that would benefit from this reality. Instead, defensive and inflationary names are getting more flows than transportation, small caps, high beta and retail sales. The market leaders continue to make lower highs while the broad market pushes higher, and bonds are getting sold as if the FED stopped cutting rates, not started. The warning signs are high, and my firm remains defensive until these signals reverse, or the market corrects.

If you want to track the potential top in equities, join I/O Fund next Thursday, October 17th at 4:30 pm EST, for our premium webinar. We will go over the levels that need to hold and the specific AI stocks we are targeting for the next leg higher.

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Knox Ridley, Portfolio Manager of the I/O Fund, contributed to this analysis.

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