Charting Macro Trends, Taking Gains In VTI Appears Prudent (Rating Downgrade)

What a run it has been for US stocks. Year to date through last Friday, the S&P 500 Trust ETF (SPY) was up 18.6% total return, while the tech-heavy Nasdaq 100 ETF (QQQ) had soared 21.2% in 2024. Small- and mid-cap equities have fared less well, though. The SPDR S&P MidCap 400 ETF Trust (MDY) is up 9.5% on the year while the Russell 2000 small-cap ETF (IWM) is higher by just 6.8% – that’s after IWM’s best week since late last year.

I am downgrading the Vanguard Total Stock Market Index Fund ETF Shares (NYSEARCA:VTI) from a buy to a hold. The fund is up 5.5% from when I went through a series of charts five weeks ago.

While it has been a short period since then, bearish seasonal trends are on the doorstep, and we all know what stocks did last summer and into the fourth quarter. The same sort of price action played out in Q3-Q4 of 2022. Could it happen for a third time? I say it’s quite possible given high investor sentiment, stretched valuations, and an uncertain economic growth backdrop.

Revenge of the Small Caps Following a Cool CPI Report. YTD Returns:

According to the issuer, VTI seeks to track the performance of the CRSP US Total Market Index and offers investors large-, mid-, and small-cap equity diversified across growth and value styles. It employs a passively managed, index-sampling strategy.

Everything appears awesome for the US stock market right now, at least when it comes to price action. Last week, we saw a remarkable relative snapback among undervalued SMID-cap stocks, while value equities enjoyed one of their best weeks versus shares of growth companies going back to late 2022. This is a technical data point that the bulls can point to as a sign of a positive broadening out of the 2024 rally, rather than a more neutral, mere rotation development.

Value Snaps Back Versus Growth

Furthermore, it was IWM’s third-best weekly gain relative to the S&P 500 going back to the year 2000 as a cool CPI report Thursday morning sparked a short-covering rally in smalls while the Magnificent Seven stocks gave background on Thursday. Just about all equity sub-asset classes rose to close out the week, though, which was an encouraging sign following Thursday’s historic trading session. All the while, the Volatility Index (VIX) remains subdued near 12.

IWM Posts Its Best Week Versus SPY Since March 2020

Volatility Typically Rises Heading Into August

All told, the Russell 2000 ETF is now leading the chart in July, rising more than 5%. This is actually not far from usual price action that we see during the first two weeks of the second half. As I noted last time, bullish seasonal tailwinds were very much in play heading into Q3. That has played out and then some.

July Returns Very Strong So Far, As Seasonality Would Suggest

But here’s the key chart for VTI. Using the S&P 500 as a proxy, which tracks very closely with VTI, the mid-July through the end of September stretch has often been riddled with volatility over the past 20 years. We saw that in 2008 and 2011 years ago, and more recently in the past two calendar years. Following a major rally so far in this election year, I expect a rockier road as the campaign season heats up.

Seasonality Turns Weaker From Mid-July Through September

Something else to consider from a risk perspective is that the yield curve has been dis-inverting. Now, recent price action has been a bull steepener – meaning that yields on short-term Treasury securities are falling faster than yields on longer-dated Treasury notes. But it’s often the re-steepening of the yield curve that gives equities fits.

2yr-10yr Yield Spread Dis-Inverting

While inflation concerns have waned substantially in the past three months, growth risks have emerged. With the Atlanta Fed’s GDPNow model showing a 2.0% Q2 growth rate, economists expect an easing of the economic expansion rate over the current quarter and next.

US Real GDP Growth Estimates Suggest Weaker Growth in 2H

Amid this apparent slowdown, equities are richly valued. According to Goldman Sachs, the S&P 500 now trades close to 22 times forward earnings estimates. That is within a stone’s throw of the earnings multiple highs from shortly after the pandemic. Much will depend on the current reporting period and high EPS estimates coming to fruition in the next few quarters. Any hiccup in profits could dent the currently high US stock market P/E.

S&P 500 Sector Valuations

Big Earnings Expectations Ahead

Stocks are less attractive on a relative basis to bonds too. I like to assess the stock-bond valuation situation via the US equity risk premium. It’s the difference between the S&P 500’s earnings yield (which is the inverse of the current forward P/E ratio) and the rate on 10-year TIPS.

Since equities are claims on real assets, the comparable measure is to analyze real Treasury yields, not the nominal 10-year Treasury rate. Today, the spread is just 2.46%, according to WisdomTree. While still positive, it’s at the lowest level going back to the early 2000s on large caps. Of course, the ERP on small caps is more like 500 basis points.

S&P 500 Equity Risk Premium Hits 24-Year Lows

Along with high valuations, investors are simply too excited right now. While periods of elevated sentiment can last for a long time, should a macro event unfold that will cause folks to feel less upbeat about stocks, we could see frothy feelings quickly abate. What’s more, it was just a year ago when weakness took air out of the market’s bubble.

Investor Sentiment Remains ‘Stretched’

I’m not outright bearish on VTI currently, however. A bullish indicator is continued depressed credit spreads, suggesting that there’s high confidence among stockholders in the ability of firms big and small to repay their financial obligations.

In fact, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG) touched fresh highs going back two years at the close of trading last Friday. It’s hard to be too pessimistic about stocks when investors are willing to own junk bonds to this extent.

HYG Junk Bond ETF Hits Two-Year Highs

Something else to watch for clues on where VTI may go is the US Dollar Index (DXY). The key spot here is 104. A breakdown under that technical level could result in the greenback falling to 101.50 based on the height of the recent range. While that could be a big tailwind for foreign stocks, a plunging dollar could imply significantly weaker economic and business conditions.

I’ll be watching how the DXY performs if it breaks 104 – if that comes with a rising stock market, perhaps on the expectation of a Goldilocks inflation and growth narrative, then VTI’s bull run could have legs into year-end.

US Dollar Index Hovers At Critical Support

Lower interest rates would certainly also be a boon for the housing market. While real estate prices continue to rise, homebuilder stocks had been sagging before CPI Day last week. A major drop in mortgage rates, corresponding to the drop in Treasury yields, helped homebuilder ETF soar.

This is another ‘upside’ risk to stocks in the next couple of quarters – lower mortgage rates could spark an important recovery in this year’s worst stock market sector: Real Estate.

Mortgage Rates Drop to the Lowest Level Since February 1

As it stands, investors see 2.2 quarter-point rate cuts by the end of the year. That’s the most expected easing since early April. June’s sanguine CPI report was the third straight cool inflation update, though Friday’s PPI report was not as encouraging.

It’s key to note what Chair Powell stated in his semi-annual testimony to the House and Senate last week; there indeed are emerging risks to growth as inflation fears abate. If we see weaker employment trends, US stocks could come under pressure as the Fed begins to ease its monetary policy.

More Rate Cuts Expected This Year

Looking ahead to this week, all eyes will be on June Retail Sales, important housing market data points, and last month’s Industrial Production readings.

This Week’s Data Deck

It’s also a big week of earnings. About 11% of the S&P 500 reports Q2 results, including five Dow components. Chip names like ASML (ASML) and Taiwan Semiconductor (TSM) report from the international market.

Other notable companies reporting earnings include Goldman Sachs (GS), UnitedHealth (UNH), Bank of America (BAC), Johnson & Johnson (JNJ), Netflix (NFLX), and a check on the consumer via American Express (AXP).

Earnings on Tap

The Bottom Line

I am downgrading VTI from a buy to a hold after a large 5% rally in a relatively short time period. Weaker seasonal trends are front and center as the Q2 earnings season presses on. Macro conditions appear fine right now, but if the growth narrative deteriorates, then investors who are currently quite optimistic may turn more defensive. High valuations are a risk, while some indicators like credit spreads remain healthy.