Bullish Momentum is Fading

Since the October 2023 lows, the stock market has been on a tear and momentum shifted in a big way in favor of bullish investors. Initially, we were 100% on board for the ride up and only started to lighten up on risk exposure in late December - early January. Since then, the market has proven to be very resilient and going in one direction only: UP.

Bears simply evaporated, as the equities experienced unusually low volatility and ever higher prices - an “unstoppable” advance. Capital chased hot stocks in “artificial intelligence”, semiconductors and miracle weight loss drugs. Since early March, we’ve signaled that the rally is reaching a potential exhaustion stage, and started to get more defensive in our allocation. Today, it does seem like we are ahead of a real turning point for the markets in 2024.

In order to identify this turning point correctly, we’ve focused on one key support level that has held up well in the past 6 months: the 20-DMA. Not only were we looking for a break of this level, but a “confirmed” break (a rejection or inability to reclaim the level). We got both last week - on Wednesday, the break occurred on account of the inflation reading, Thursday’s rally stopped just short of the 20-DMA (rejection), and Friday’s drop confirmed our technical thesis. This type of price action shows that cracks are appearing in the bull run.

Now, we need to understand if a deeper correction is at play, or if the market is just consolidating a few percentage points below its all-time-highs. In the short term, SPY is sufficiently oversold to elicit a bounce, early in the week. In the medium and longer timeframes, we believe that a corner has just been turned and investor psychology is shifting.

Immediate risk-reward seems balanced: upside rests at $527 (R2, +3.16%), while support should be found at $499 (R1, -2.31%). However, failing at R1 support means that the market can retrace further, to the 200-DMA. While rare, a 200-DMA retracement is a common technical price move which tends to occur 2 - 3 times per year. Since the market does not move in a straight line, we can assume it will take a while to get there, and the 200-DMA will advance to $480 - $490 by the time the retracement is complete. This would entail a steeper total drawdown, of about -8% from ATH. As we’ve pointed out numerous times, a -5% to -10% correction is on the table in any given moment for equities.

The MACD signal is now sufficiently extended to the downside as to elicit a short-term reversal. It would not be surprising at all to see some sideways price action in the next couple of weeks as earnings season winds up. Normally, earnings season is supportive of equity prices, as companies regularly beat lowered estimates.

However, investors also need to justify owning stocks at valuation levels which have rarely been exceeded in history.

Even taking a cursory glance at the Forward 12-month EPS versus price change in the S&P 500 reveals a staggering disconnect. Year-Over-Year earnings growth is expected to be around 7% for Q1 2024, which doesn’t really jibe with SPY’s recorded 12.5% CAGR.

The two instruments we would look at in order to ascertain investor sentiment and market direction are the Momentum Factor ETF (MTUM, which regularly rebalances holdings for what’s hot in the market) and Bitcoin, which has acted as a leveraged bet on tech recently (BTC-USD). Both of these names exhibit eye-popping recent performance, but we can’t really compare them using percentage returns due to the different inherent volatility.

Instead, we can use Z-Score (standard deviation from the regression line) and the overall chart pattern. We find a similar setup, with both sentiment-driven instruments appearing “toppy” and highly extended (not a great combo).

The issue with sentiment driven trades is that they work great on the way up, while investors are enthusiastic (fast gains drive more investment and more gains). The same psychology works in reverse, when gains no longer materialize to the same degree (or turn into losses). Howard Marks said it best:

“It’s the swings of psychology that get people into the biggest trouble, especially since investors’ emotions invariably swing in the wrong direction at the wrong time. When things are going well people become greedy and enthusiastic, and when times are troubled, people become fearful and reticent. That’s just the wrong thing to do. It’s important to control fear and greed.“

The reason why we are keeping a close eye on sentiment gauges is that the current market environment has only been driven by optimism and little else. Rationally, it does not make sense to hold stock index-related funds which have ~5% fundamental upside and are exposed to a lot of downside, when the risk-free rate is almost identical (treasury bonds currently yield 5.13% at the 1 year maturity).

In this type of market “Sellers live higher and buyers live lower”. In order to determine the prices at which buyers and sellers meet, we need to examine transaction volume. What we’re currently seeing tells us that the next upside spike in volume will occur on lower prices, not higher ones. Currently, there’s below average liquidity support for another bullish advance.

However, not everything is “doom and gloom” and not all stocks are a SELL. Some quality names have already recorded drawdowns in excess of -10% (AAPL and ADBE come to mind as an example). Using our Stock Screener, we can find some of these companies and ascertain the quality of their fundamentals. Here is the screener set-up:

• Pietroski F-Score > 5 (ensures quality)

• Current Drawdown Maximum set at -9.5% (has at least a -9.5% drawdown at the moment)

• Z-Score Relative set at a Maximum of 0 (underperforms benchmark); also sorting criteria

The top 20 list includes some very interesting names at attractive entry points from a strictly technical perspective: ZTS, LULU, BA, UNH, MCD, ADBE.

Our Trading Strategy

Every good thing comes to an end, eventually. It’s only a matter of time and exact circumstances. We’ve been saying for a while that fundamentals do not currently support equity prices. Fair value for SPY should be around $500 in order to support a potential 1-year appreciation of 9.15% (5.15% risk free rate + 4% Equity Risk Premium).

Fluctuations in sentiment will make assets trade both higher and lower than their fair value at various times. While we’ve currently cleaned up a lot of our portfolio positions, the overall state of the market can offer up some bargains as well. It’s important to also pay attention to these and not entirely dismiss buying while corrective phases gather steam. Since the market is oversold in the short term, a bounce this week could be a good opportunity to sell into, in order to rebalance holdings.

Our actions for portfolio management revolve around risk management:

• Tighten Stop Loss Levels

• Take Profits / Stop Out positions where needed

• Remain vigilant for overlooked opportunities

We’ll discuss more in our Portfolio Rebalance Article and keep you up to date with our live trading in the meantime.

Signal Sigma PRO members will be notified by Trade Alert of any live portfolio changes (if subscribed). If you’re not on this plan yet, you can get a free trial when you join our Society Forum. If you need any help with your trading strategy (or would like to implement one on your account), feel free to reach out!