Genuine Rally Or Is There More Downside Ahead?

Admin Notice: this week, our Daily Briefings will be more short and concise than usual - we are taking a small break for Labor Day and Orthodox Good Friday.

Two weeks ago, we posted the following technical take for the price action of the equity market, with 3 potential outcomes:

A: Reflexive bounce, rejection, then drop to support

B: Reflexive bounce, consolidation, then run to all-time-highs

C: No reflexive bounce, drop direct to support

Up until last week, the markets seemed to follow the direction of path C, with the S&P 500 notching a -5.5% decline after six consecutive down days. Some of the bears emerged from hibernation and started to preach “doom and gloom”. Risk sentiment leader NVIDIA (NVDA) declined almost -20%. Technical levels were breached. Yet volatility increased only modestly, with little “panic selling” evident in the market. On the contrary - the decline was orderly.

With many short term indicators signaling “Oversold”, and sentiment turning “Neutral”, we warned that a “reflexive rally” would be the expected outcome. After all, markets rarely move straight up or down without any respite. Last week, we got that rally after Google and Microsoft reported blowout earnings. Notably, Meta’s miss that led to a -1.4% decline at Thursday’s open was not enough to create follow-through selling and retest recent lows. In other words, the market has proven itself to be resilient.

We have now reached an intersection, with only paths A and B viable from our original analysis above. For SPY, significant resistance resides just in the area of the last close, as both the 50 and the 20 DMAs are capping the advance in the short term. A clean break above both averages, by the end of this critical (and potentially volatile week) will set up the market to reach new all time highs (scenario B). Conversely, a failure at resistance would imply a retest of recent lows (scenario A). The next level of support would be $486 (M-Trend, -4.37%).

The MACD signal will soon trigger a BUY from a fairly low reading. Along with Thursday’s resilience, this tells us that the bullish case is building. Furthermore, declines in the broad market have not tracked with declines in the SPY during this correction episode. Our Z-Score divergence chart below proves the point:

We can also draw some conclusions from the Dollar Transaction Volume, which did NOT spike during the whole downturn. Below average volume on lower prices does not confirm the correction trend.

There are a couple of potential explanations for the low-ish liquidity situation, which may have contributed to the selloff. First of all, there was a sharp increase in the Treasury General Account (TGA). While the Fed’s balance sheet declined from $7.43 trillion to $7.40 trillion, the TGA surged from $675 billion to $930 billion last week. This happened due to relatively large auctions by the Treasury to fund current expenditures.

Eventually, this money will find its way into the economy, boost company earnings growth and translate into higher asset prices. The coming liquidity injection will support the market, and keep the correction from transforming into a more considerable decline. With the TGA now refilled to recent high levels, t-bill issuance will probably be reduced, supporting lower yields and higher valuations.

The second reason why there was a liquidity slump is the lack of buybacks. Corporations are an essential buyer of equities in the current environment and the blackout window for share buybacks occurs 4-6 weeks prior to earnings announcements. This period has been ongoing for about a month and is now close to ending as 20% of the S&P 500 is reporting earnings this week.

That means that many more corporate share buybacks will resume in the next couple of weeks, and with more than $1 trillion slated for 2024, many buybacks remain to complete. Such is particularly the case with Google adding another $70 billion to that total.

This is another potential boost to liquidity which will act to limit any meaningful drawdown.

Sentiment has not exactly bottomed according to our measure, but has cooled off significantly. We are now getting a “Neutral” reading, which is much more friendly for initiating new positions. Not an ideal setup, and no “Extreme Fear” just yet, but there’s certainly nothing “wrong” with adding risk exposure here.

Our Trading Strategy

It’s important to restate that as investors, our job is to determine possibilities, weigh probabilities, and take the course of action that best leads to our financial goals. If you are following our live portfolio, you’re likely aware that we’ve turned defensive for a while (defensive doesn’t mean “sell everything and go to cash”).

Going forward, there are no guarantees that the current bout of selling has ended. This week features many potential bearish catalysts:

• The Fed will react for the first time to rising PCE, PPI, and CPI inflation data; Jerome Powell could tank risk sentiment with a hawkish sounding speech;

• Apple is reporting earnings on Thursday and, despite being oversold, has received mixed analyst recommendations in April; the mean price 1-year target for AAPL has remained steady for about 6 months and there were no meaningful upgrades in the interim;

• Finally, the April jobs report will be released on Friday;

We’ll take small steps to increase exposure at this junction, in positions which present an improved risk-reward ratio. These positions have a limited correlation to the broad market and should prove to be resilient through most scenarios. By the end of this pivotal week, we’ll know if scenario A or B is viable into the rest of 2024.

Even if the bears prevail for the next month or so, there is nothing to suggest that this episode is more than a normal correction for now.

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