Expect Volatility - MMM v6-5
On Monday Nvidia lost $589 BILLION on market cap, a new record. Nvidia alone accounted for 2/3 of the drop in the S&P 500 index. We have discussed the lack of diversification and concentration risk in the S&P 500 occasionally the last couple of years. Monday was yet another example of the dangers of owning a passively managed index fund.
Click here to jump to our discussion on Tariffs
Nvidia is no stranger to record market cap drops. They now hold 8 of the top 10 biggest drops in US history:
Nvidia is no stranger to record market cap drops. They now hold 8 of the top 10 biggest drops in US history:
The catalyst for this as mentioned at the top of last week's blog was concern over the Chinese open source AI app DeepSeek latest version which was said to only cost $6 million to develop as it is able to run on much less powerful chips than the Nvidia chips which cost hundreds of millions of dollars each. Not only does this threaten Nvidia's estimated $200 Billion in revenue for 2025, but it would make the tens of billions of dollars other S&P 500 companies spent on those chips "wasteful". The earnings expectations for the S&P 500 are largely reliant on both Nvidia posting 25%+ revenue growth as well as their customers being able to monetize their AI spending by boosting their own revenue by 15-20% plus this year.
If either Nvidia does not hit their targets or we see a "write-off" of their customers big spending the chances of the S&P hitting the optimistic forecasts are diminished. If both occur, we could see a bear market rather quickly given the historic high valuation levels. It's a big week for earnings, especially from tech companies with Amazon and Google set to report earnings this week. Overall 131 of the S&P 500 companies will be reporting.
I'm not calling a new bear market (yet), but this is something to watch. History doesn't rhyme, but it does repeat. The tech bubble burst slowly after earnings slowed down in the middle of 2000 due to the fact pretty much anybody who owned a computer had spent money upgrading their technology for the "Y2K bug". This artificially boosted revenue in 1998 & 1999 and analysts and investors expected that growth to continue as well as for companies to continue to see their margins increase due to the productivity gains from their upgraded technology stacks.
That obviously didn't continue and we had a 2 1/2 year bear market which wiped out half the value of the S&P 500 and over 85% of the tech-heavy NASDAQ.
Trump vs Fed (Again)
On Wednesday the Fed announced no change to their interest rate policies. In the statement and press conference they re-emphasized they would be "data dependent" and they still believe inflation will continue moving lower. At the same time the Fed emphasized there is no need to rush in lowering rates again.
This led the President to respond with another attack on the Federal Reserve:
When asked about the President's comments, Chair Powell said: "I’m not going to have any response or comment whatsoever to what the president said. It’s not appropriate for me to do so." This of course isn't his first rodeo as Chair Powell, who was appointed by Trump in 2018, endured constant criticism from the President during Trump's first term. Powell's term is up next year. Most people do not expect Powell to give in to the President's wishes and demands, which means at some point in the next 18 months there will be a big question about who will be the next Fed Chair and what that will mean for the economy, inflation, and the bond market.
Fed Forecasts Highly Uncertain
Speaking of the Fed, one of our fund partners, Anchor Capital's Chart of the Week highlighted the Fed's own internal uncertainty for their economic outlook in this chart. It plots the 'risk' they are assigning to their own forecasts being "wrong". If members of the Fed are not clear on the outlook, should we really be banking on them getting it "right" with their own policies? As we highlighted in our January Economic Update, there is probably too much focus on the Fed making things "easy" for stocks, when that isn't their job.
Tariff Threats become Reality
After some wavering over the last week, tariffs of 25% on Canada and Mexico and 10% on China imports appear to have been put in place on Saturday and expected to be implemented by Tuesday. The specifics are still somewhat vague. As of this writing there was no official list of everything that will be impacted and there are rumors there may be exceptions for specific companies or products although the President has denied there is any room for exceptions.
The full list should be made available hopefully later in the day on Monday. When asked Friday about whether this included oil imports from Canada, the president said, "maybe". There is language in the official order that Canadian energy imports will be subject to a 10% tariff instead of 25%. The stated reason: immigration, fentanyl, and trade deficits pouring across both borders. China also is going to "pay for it" because they send "a lot of fentanyl to our country. A lot of it." As currently written it appears ALL Chinese products are currently subject to the new 10% tariff.
UPDATE: about an hour into the market day on Monday, Trump announced on TRUTH Social the Tariffs on Mexico would be delayed by one month.
Canada has already declared they are implementing identical tariffs in two phases, starting next week. While Mexico has not officially retaliated, they are expected to over the next week. Both countries had already committed more money and resources to stopping illegal drug shipments coming across the border, so the logic of the tariffs must be to get them to commit even more resources. China for its part has filed a protest with the World Trade Organization.
There is a clause in this order that allows the President to increase both the amount and products covered if any of the countries retaliate.
Since we already have legally binding trade agreements in place, the President used the already declared "economic emergency" as the basis for these tariffs.
This will hurt the US automotive sector more than any other given how much of their materials are manufactured in Canada and Mexico. The Wall Street Journal discussed this in an article on Friday. 22% of all cars sold in the US were built in Canada or Mexico. GM, which is thought to be an American car manufacturer produced over 25% of their cars sold in the US in Mexico or Canada. Half of their top selling Silverado and GMC Sierra trucks were made in Canada or Mexico.
Car prices were already a primary driver of inflation. I'm not sure how this will help lower inflation. I'm not saying it doesn't need to be done, but do we really think Americans are willing and able to pay much higher prices to purchase only made in the US vehicles?
Let's also not forget grocery prices. Mexico is our primary source for imported fruits and vegetables – $45 Billion last year. Canada farm imports were $40 Billion. Our country is already facing an egg and chicken shortage with another outbreak of bird flu. How long will Americans tolerate grocery prices going up when they thought they were voting for lower grocery prices?
Goldman Sachs has estimated a sustained 25% tariff on Canadian and Mexican imports would cause core prices to go up by 0.7% and GDP to take a 0.4% hit. The lower tariff on oil may change those numbers slightly. The Goldman team has estimated an overall 20% tariff on Chinese imports, which would boost core prices another 0.3% and drag GDP by 0.2%. In other words, Goldman Sachs estimates inflation being 0.7% higher just from these two actions and GDP to be 0.6% lower.
This does not include what is likely to be a rather hostile trade war with Europe based on the latest comments from the White House. the president said he would impose tariffs on computer chips, pharmaceuticals, steel, aluminum, copper, and oil and gas, "fairly soon" and the European Union will also see some because "they've treated us very poorly."
This of course makes the Fed's job even more difficult — do they fight the increase in inflation due to these tariffs with higher interest rates or lower rates to help the economy digest them and risk inflation getting out of their comfort level once again?
What type of outrage would we see from the White House if the Fed were to raise rates due to the inflationary pressure of the tariffs (and other spending)?
So far the markets are not happy, but that is to be expected. We saw this a lot in 2018 when the trade wars really heated up during Trump 1.0. Back then, Trump would back off basically any time the Dow dropped 3-5%. On Sunday night, President Trump warned there could be "some pain" from the latest trade war. He also again hinted that Canada should become the 51st state because it would "cease to exist" without the trade surplus with the US.
The President does have more momentum than he had in his first term. He is polling more favorably across the board than he did in 2017 and most certainly ahead of when he left office in 2021. Time will tell how patient Americans will be with this shift in priorities from lowering grocery prices to fighting the war on fentanyl, something that is not at the top of most American's priorities.
I will again remind everyone that while the start-to-finish overall returns were above average during the first Trump presidency, it was not smooth sailing. In his first term the first year was focused on tax cuts and regulatory changes. That gave the market a huge boost, but as soon as the tax cuts were done, Trump shifted to his Trade War (mostly) with China. 2018 was a very tough year for stocks.
At SEM we do not focus on economic policies, make projections on what they may do to stocks, but instead follow what Wall Street is doing with their money. For whatever reason, since the election they have been mostly focused on tax cuts and regulatory changes, expecting the President to not act so quickly (despite his promises to do so on Day 1.)
Now we will wait and see what Wall Street (and Trump) do. Which is more important, keeping promises to "fix" the trade deficit and make more stuff in the US, cutting prices, or boosting economic growth. The President believes (or at least he tells us he does) that tariffs will pay for all of his economic policies including extension and expansion of the tax cuts. That's never been the case in the history of the world, but maybe this time is different.
Our trend following models are designed to allow volatility and generally won't even begin to react until the stock market has lost 7-12%. This is due to the fact 5% drops are common (on average 3x per year) and 10% drops happen about once a year. 12% drops historically tend to turn into 20%+ drops as fear sets in that this is beyond a normal correction.
Right now (see charts below) the S&P could fall 5% and just be back to the post-election lows. When/if we get there we will see how much appetite the President has for stocks falling below the election day levels he seemed to be highlighting daily in November and December.
Again, I've said for nearly two decades, the United States NEEDS to fix our dual deficits (trade and budget). The problem is doing so requires SHORT-TERM (2-5 years) of pain in order to fix all the structural problems which led to these deficits. It will take a President and elected leaders who are both able to stomach short-term drops in polling numbers and more importantly convince voters we are going in the right direction. Please don't take any of this as a slam or endorsement of the President, but rather a reminder that whether you like him or not, at least for now we are talking about ways to fix both of our deficits.
The question is can he convince voters it is the right thing to do or will Americans again complain about any short-term set-back to their standard of living and throw Republicans out of power in 2026.
That's not our job to guess. Stay tuned. It's gonna be an interesting ride.
Market Charts
After hitting all-time highs in the first week of Trump 2.0, the AI driven sell-off started the week off on a negative note. Stocks had nearly recovered all of the losses by Friday, until the President reiterated the start of the 25% / 10% tariffs on Canada/Mexico and China respectively.
While the President likes to take credit for the stock market rally, this chart serves as a reminder that the rally started in the fall of 2023 when the Fed hinted they were not only done raising rates, but would be lowering them aggressively in 2024. That uptrend is still in place.
Looking at the rest of the market, Mid Caps continue to lead the pack with bonds once again landing at the bottom of the chart.
Going back to 2022, large caps are still the clear winner, but as we've mentioned many times a healthy market needs small and mid-caps to participate.
The "risk-off" sell-off to start the week did help push bond yields lower. Inflation readings in line with expectations also helped end the uptrend in rates (for now).
The direction of interest rates will remain the most important area to watch in the markets. The President cannot "demand" rates go lower for longer-term bonds. That is up to the free market and will be based on what the consensus viewpoint is on the various ideas being implemented by the President.
SEM Model Positioning
-**NEW** Tactical High Yield reentered the high yield bond market after about 5 weeks on the sidelines. We had added a 30% position in floating rate bonds on 12/6/24, which currently have a 9% yield compared to a 6% yield in high yields and 4.6% in money markets.
-Dynamic Models are 'neutral' as of 6/7/24, reversing the half 'bearish' signal from 5/3/2024. 7/8/24 - interest rate model flipped from partially bearish to partially bullish (lower long-term rates).
-Strategic Trend Models went on a buy 11/27/2023; 7/8/24 – small and mid-cap positions eliminated with latest Core Rotation System update – money shifted to Large Cap Value (Dividend Growth) & International Funds
SEM deploys 3 distinct approaches – Tactical, Dynamic, and Strategic. These systems have been described as 'daily, monthly, quarterly' given how often they may make adjustments. Here is where they each stand.
Tactical (daily): On 12/20/2024 our tactical high yield model sold out of high yield bond (about 70% of our holdings) into money market. The other 30% is invested in shorter duration, higher yielding floating rate bonds. These instruments are not as sensitive to credit risk and are typically allocated to in the early and late stages of a high yield bond move in our model.
Dynamic (monthly): The economic model was 'neutral' since February. In early May the model moved slightly negative, but reversed back to 'neutral' in June. This means 'benchmark' positions – 20% dividend stocks in Dynamic Income and 20% small cap stocks in Dynamic Aggressive Growth. The interest rate model is slightly 'bullish'.
Strategic (quarterly)*: BOTH Trend Systems reversed back to a buy on 11/27/2023
The core rotation is adjusted quarterly. On August 17 it rotated out of mid-cap growth and into small cap value. It also sold some large cap value to buy some large cap blend and growth. The large cap purchases were in actively managed funds with more diversification than the S&P 500 (banking on the market broadening out beyond the top 5-10 stocks.) On January 8 it rotated completely out of small cap value and mid-cap growth to purchase another broad (more diversified) large cap blend fund along with a Dividend Growth fund.
The * in quarterly is for the trend models. These models are watched daily but they trade infrequently based on readings of where each believe we are in the cycle. The trend systems can be susceptible to "whipsaws" as we saw with the recent sell and buy signals at the end of October and November. The goal of the systems is to miss major downturns in the market. Risks are high when the market has been stampeding higher as it has for most of 2023. This means sometimes selling too soon. As we saw with the recent trade, the systems can quickly reverse if they are wrong.
Overall, this is how our various models stack up based on the last allocation change:
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