Notable Events on our Weekly Watchlist:

Monday: NAHB Housing Market

Earnings: N/A

Tuesday: EU Zew Sentiment, Building Permits, Industrial Production

Earnings: WMT, A, HD

Wednesday: UK Inflation, Retail Sales, FOMC Minutes

Earnings: LOW, CSCO, TGT, TJX

Thursday: Jobless Claims, Existing Home Sales

Earnings: AMAT, EL, KSS, ROST, WB

Friday: N/A

Earnings: DE, FL

ETFs to watch: SPY, XLY, XLP

Panic is the word of the day. But this week, the panic we are witnessing serves buyers, not sellers. Algorithms and discretionary traders alike have found themselves on the wrong side of a furious advance in the markets. They were forced to play "catch-up" as several technical levels have been breached, proving that low liquidity moves prices very fast on the way up as well as on the way down. Our own Horizon Strategy has gone 90% Risk-On last Tuesday, ahead of the inflation report that sparked the whole move. We have executed part of that trade with discipline in the Sigma Portfolio, but we're still cautious on equities in the short term. We will further explore both the bullish and bearish scenarios.

SPY Analysis

The good news is that SPY has closed in its "regular" technical channel (between the two regression lines that run from Z-Score 1 to -1). This setup gives our models the "green light" to target equity exposure. The last time we had stocks climbing back up above the lower technical trendline was May 2020, when the Fed aggressively stepped in to save the markets via extreme levels of QE.

Although technicals look very similar, the fundamental backdrop is markedly different this time around. Inflation is 8.5%, and the Fed is on a path to tighten financial conditions, not loosen them. Liquidity is slowly getting drained from the market as the next chart shows.

Volume Analysis

Our Market Internals - Volume instrument measures transaction dollar volumes across the top 1000 stocks. As the Fed raises interest rates and ramps up QT, you can actually see the polyline average start to trend lower. In other words, there are less dollars changing hands every given day, for the same amount of stocks issued. This is not an environment that can be conductive to higher equity prices in the long term. If anything, lower liquidity argues for more volatile stock movements, both lower AND higher.

According to Goldman's flow analysis, this week has seen one of the most extreme short covering events in the past 10 years. Our Internals analysis agrees.

Market Internals - Overbought / Oversold Analysis

Reading this instrument is pretty straightforward this week - it simply can't get more extended to the upside short term. The number of stocks rated as "overbought" is well higher than 2 standard deviations above the mean. This is the polar opposite of the mid-June situation, that saw one of the most oversold markets in recent memory. While the absolute best performers of the recent rally have been the most shorted stocks (high-beta tech stocks, consumer discretionary, meme stocks), there is a glaring anomaly in the sectors performance rankings, not typical of risk-on positioning: Utilities.

XLU Analysis

Utilities are trading near the top of the technical channel, with a Z-Score of 0.93. The only recent time when Utilities have been priced so dearly was the month of April 2022. During April, the S&P also saw a broad market recovery, that later became known as a “bear market rally”. Utilities are a defensive sector, proffered by investors during times of heightened volatility. Along with Consumer Staples and Healthcare, this trifecta of industries is considered “recession proof”, as consumers cut back on spending for these items as a last resort. So why is a defensive sector like utilities rallying to this extent?

The only probable answer: investors don’t fully buy into the whole Fed pivot narrative. Whatever sparked the recent rally was more related to short term supply-demand dynamics in the market (or different mandates to chase prices above certain levels). Fundamentally, a lot of participants are preparing for the worst.

Takeaway:

While the recent rally has certainly been encouraging for the bulls, it has gone too far too fast. We have diligently executed part of Horizon’s positioning in the Sigma Portfolio and our P/L is positive for these positions. However, we need more confirmation that prices will stick. We need to wait for a decent pullback to recent support levels before committing any more capital to risk assets. To be clear, the area of support most likely to hold is around 392 - 413. That is more than a 3% decline from current levels. If these levels are breached to the downside, that will invalidate the “new bull market” thesis, and we will have to rethink our approach. Until then, some profit-taking might be in order.

Andrei Sota