Market’s momentum tests our patience

Stocks continue to trade higher, in yet another week of suppressed volatility with grinding price action. The FOMC’s decision to raise interest rates was treated as a non-event by the equity market. The treasury market, however, recoiled as the Fed’s “higher for longer” mantra gets priced in and reflected as higher yields.

Overall, the S&P 500 closed out its 5’th straight month of gains, with unusually high YTD returns (19%). If we look at the six prior times the S&P 500 was up five straight months in July, the return for the year’s balance was 8% on average with a 100% win rate. Plenty of recessionary signals argue that the price performance is detached from reality:

• The Conference Board Leading Economic Index (LEI)

• Liquidity measures (M2 - GDP)

• ALL 10-economically sensitive yield curves inverted

A recession in the real economy should directly translate to lower equity prices in the financial economy as well. Contrary to this belief, the rally that started in October surprised many investors, both retail and professional. As a consequence, many have been sitting on the sidelines (or have been actively short), and the pressure to chase returns has only been exacerbated in the last couple of months. We suspect this is the psychological reason behind the seemingly “unstoppable” bull market advance. Investors are currently as optimistic as they can get.

As we will explore below, the market advance has been entirely based on valuation expansion and nothing else.

SPY Analysis

Technical Analysis and quantitative data help us navigate the market that we get, not the one that we’d like to have or the one that makes sense. Notably, Technical Analysis is a risk management practice, not a “prediction” device. We are looking to form a longer term projection (aka - bull or bear market), and a shorter projection that would allow us to deploy capital opportunistically.

Currently, we are in a bull market advance, and equity risk exposure is clearly warranted. In the short term, equity indexes are overbought and remain prone to a loss of momentum (as already evidenced by the MACD signal), simply as a function of buyers exhaustion. A pull back to the R1 support level, near the 50-DMA at $431 on SPY would be a good opportunity to increase risk in portfolios. Right now, all of our indicators suggest using caution in committing our cash reserves.

Sentiment is no longer at “Extreme Greed” levels, but is still far from signaling any sort of fear.

Transaction volume has fallen a bit short of the average in the past week, suggesting that further advance on the back of liquidity is limited.

Got bonds?

The stock market advance puts treasury performance to shame in 2023. An economy that is mostly stable, resilient, and performing above analyst estimates gives Central Banks no reason to “pivot” or intervene in any stimulative way for now. To adequately compensate investors, yields need to remain at elevated levels, keeping treasury prices confined currently.

That explains why the SPY / TLT ratio is reaching a 1 standard deviation extreme reading:

With our strategies rebalancing portfolios today, it’s no surprise to see targeted treasury exposure increasing. Technically, we are still waiting for a valid short-term BUY signal on bonds, but the higher level asset allocation decision to favor bonds over stocks is a no-brainer at this juncture.

We simply need to be aware of the fact TLT is still facing significant technical downside, while a decent upside catalyst remains elusive.

Higher for longer yields play an integral part in companies reported metrics. As mentioned at the start of the article, the equity rally has been solely based on valuation expansion and nothing else. Paying more for an asset that has the same metrics, looking to get compensated by future growth certainly exposes investors to being disappointed. So far, earnings released for Q2’2023 have failed to move the needle where it really matters - Revenue Growth, Margins and EPS.

The Risk / Reward setup for Earnings Headliners

Apple (AAPL) - Price Target $182 / 10.0% EPS Growth

Our DCF Model works with the following assumptions:

Revenue Growth: 9%

Gross Margin: 43%

Operating Expenses % of Sales: 12%

Share Count Growth: -1%

EV / EBITDA Multiple: 17.5

WACC: 9.1%

Tax Rate: 21%

Our Trading Strategy

Similar to last week, we are simply letting our portfolios run, while making minor, opportunistic adjustments along the way. Long term treasuries are a screaming BUY, given the right trading signal.

As has been the case for the last month or so, we are patiently waiting for a better opportunity to add equity risk to portfolios. A technical pullback to either support level on SPY would satisfy our risk-reward criteria.

As far as potential catalysts go, Friday’s Unemployment Rate (3.6% exp.) and Non Farm Payrolls (190K exp.) as well as Apple’s earnings on Thursday should be able to move the market - we expect relatively smooth sailing until then.

Signal Sigma automated strategies are rebalancing portfolios today. We’ll cover the trades in tomorrow’s article.