Bullish bias persists

Last week we wrote:

We conclude that the most likely path for stock prices is higher, over the next couple of weeks.

This simple and efficient statement was proven correct by last week’s price action. Bulls are still firmly in charge of the narrative for the time being. Buyers pushed SPY above the key $402 level (S1) that denotes a “break-out”, and signals a shift for algorithmic strategies. Above $402, trend following models will start buying dips and selling outsized gains, suppressing volatility as a side effect. Overall, markets have become overbought in the short-term, and some consolidation would not be surprising. Bulls need the $402 level to hold in the event selling pressure accumulates.

SPY Analysis

After a series of technical “lower lows”, we can now confirm that the market has successfully formed a “higher low”. This has been our assumption all along, and the main reason we have increased equity exposure in our portfolio.

SPY’s Sigma Score (the cumulative deviation from key moving averages) is flashing “Overbought”, with the highest contributing factors being the large deviations above its 20 and 200 day moving averages. We’ll take this to mean the current rally has reached a stage where some consolidation is in order until the next push higher.

OPEC cuts oil output

OPEC+ announced on Sunday oil output cuts of around 1.16 million barrels per day. The surprise decision will jolt energy markets and boost oil prices in the very short term. Let’s take a look at the timing of these production cuts and what they may mean for the overall trend.

We have overlaid arrows corresponding to an increase in production (green) and a decrease (red) on the chart for USO (US Oil ETF). Unsurprisingly, the expansion of output correlates well with an increase in price, while production cuts happen amidst faltering demand and lower prices. Why would oil demand be slowing, if the world economy is humming along well, however? (Note that the price had been exceeding the lower limit of the trend channel recently, signaling a potential fundamental problem, not just a supply/demand imbalance).

With China’s reopening, there had been a speculated rise in consumption of commodities, which has not been reflected in prices so far. The latest Caixin Manufacturing PMI, released this morning came in at 50, below consensus estimates of 51.7, and signaling activity is neither expanding nor contracting. Since we know for a fact that China’s consumption is adding to demand, the counterbalancing force must be coming from the western economies, which are showing a lack of consumption.

With a sales to inventory ratio at a historical low (this chart runs from 2010 with weekly data points), there is little reason US companies need more “stuff” in their warehouses. We were expecting massive discounts and deals in Q4 of 2022, but these failed to materialize. Companies instead opted to limit discounts and hold on to merchandise in the hope consumers will eventually “pony up” and start shopping.

However, the latest revision to Q4 2022 GDP data suggests consumer spending fell in December, and demand for goods remains soft.

Takeaway

With the market rising to our technical targets, we are again faced with a dichotomy - technicals are strong and suggest equity risk is warranted in portfolios, while serious cracks are showing in the fundamental thesis. While we are maintaining an allocation level more commonly associated with bull markets, this is a risk exposure we are willing to lower fast, when conditions change.

At 52% equity risk exposure, 20% Long Term treasuries and 20% Short Term treasuries, we are at target allocation for now. We are looking for support at $402 to hold on SPY. Similarly, we are not expecting TLT to rally past the recently established highs. If either of these will happen, it might warrant a material change in portfolios.

As always, we will keep you in the loop via our trade alerts.