/ December 04 / Weekly Preview
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Monday:
N/A
Tuesday:
ISM Services PMI (51.5 exp.)
JOLTs Job Openings (9.4M exp.)
Wednesday:
N/A
Thursday:
Initial Jobless Claims (225K exp.)
Friday:
Non Farm Payrolls (160K exp.)
Unemployment Rate (3.9% exp.)
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Monday:
N/A
Tuesday:
Autozone AZO
Asana ASAN
Box BOX
MongoDB MDB
Signet Jewelers SIG
Toll Brothers TOL
Wednesday:
Brown-Forman BF.B
Chewy CHWY
GameStop GME
Thor Industries THO
Veeva Systems VEEV
Thursday:
Broadcom AVGO
Lululemon Athletica LULU
DocuSign DOCU
Dollar General DG
Smith & Wesson Brands SWBI
Friday:
N/A
The Dollar Breaks Down
Last week, most major asset classes rose on an understanding that the Central Bank is done with raising rates. The question of “one more hike?” is now becoming “when will the first cut arrive?” and “how many cuts are there going to be in 2024?”. Even if the Fed does not want to explicitly admit that the tightening cycle is over, market pricing is way ahead of them.
With that understanding, SPY rose +1.04%, Gold (GLD) gained +2.95% and long term treasuries (TLT) ended the week up +3.04%. Commodities (DBC) fared worse, finishing the week nearly flat, at -0.50%, on assumptions that inflation does not need additional hedging using hard assets. The US dollar (UUP) ended the week on a flat note, showing surprising resilience in the face of lower yields.
As it stands, SPY is grinding its way higher to our $467 year-end target (just 1.74% of upside left), with retail and professional investors in quite the exuberant mood.
SPY Analysis
The MACD Signal has flatlined, as the acceleration of prices comes to a halt, in a topping process
As the title of this article suggests, part of the outperformance in most asset classes can be partially explained by the recent downturn in the US Dollar (UUP ETF). After a relentless surge higher since mid-summer, the Dollar has taken a heady dive, retracing part of that advance. The Dollar is down -2.8% against a basket of peers since the recent top established on November 01.
Driving the Dollar lower are lower yields on treasury bonds. In turn, lower yields attract valuation premiums and boost stock prices. Lower yields are also a bullish driver for non-yielding gold, which is making headlines this morning after hitting all-time-highs in the Asia session. As the dollar goes lower, we expect “everything else” to turn higher in the near term.
Technically, UUP has a further -2.9% downside to the next logical area of support (S2, lower trend-line). Such a decline would surely put further upward pressure on most other asset classes.
Extreme Greed
The equity market has finally reached overbought and extended levels of sentiment which closely align with previous market peaks. In the past 2 years, these types of overbought conditions have been excellent opportunities to take profits and reduce exposure. In fact, following the signals derived from this instrument has a 100% win ratio if one were to buy at the lows and sell at the highs.
Here’s the catch: this strategy would have only worked in the past 2 years - it is a function of the “range trading” environment we are currently trading in. If applied through a longer period (2007-2021 especially), results are nowhere near that stellar. 2007 - 2021 was dominated by “trend following” systems, which increase exposure near market tops (also called “breakouts”). Contrary to a trend-following signal, one would expect to be a seller near relative tops when trading in an established range.
So the question investors need to answer is if this “range trading” environment will continue to persist. No matter how good an indicator is… 100% is a win ratio that is unsustainable. Is this time different? (at some point, it will be)
The reading from our own sentiment measure is mirrored by the AAII investor sentiment survey:
“Optimism among individual investors about the short-term outlook for stocks continued to rise in the latest AAII Sentiment Survey. Meanwhile, pessimism decreased to its lowest level in almost six years. Both types of readings have historically been followed by below-average and below-median six-month returns for the S&P 500 index.
Bullish sentiment, expectations that stock prices will rise over the next six months, increased 3.5 percentage points to 48.8%. Optimism is unusually high and is above its historical average of 37.5% for the fourth consecutive week and the fifth time in eight weeks.
Bearish sentiment, expectations that stock prices will fall over the next six months, decreased 4.1 percentage points to 19.6%. Pessimism is unusually low, at its lowest level since January 3, 2018 (15.6%), and is below its historical average of 31.0% for the fourth time in 11 weeks.”
- November 30 AAII Survey
"The 4-week change in AAII Bear Index is one of the largest drops we have seen in the last 20yrs." - Goldman Sachs
In this case, selling at this particular juncture becomes the consensus view. It’s the trade that anyone can safely advise. While there’s nothing wrong with taking profits, we would argue that another approach would be best. Let’s see what isn’t quite trading at extremes just yet.
The obvious candidate for a non-extreme extension is the iShares Russell 2000 ETF (IWM). The benchmark ETF for small caps still has plenty of upside left until reaching previous tops - around 6%.
Mid-Caps (MDY) also enjoy the potential for more upside (around 3%). While lower than small-caps, the gain potential is still better than SPY, which only has about +1.7% short-term upside left. However, both of these charts, representative of the broad market, still look to us like true “range trading” patterns.
Our Trading Strategy
With markets overbought and extended, the obvious trade here is to take profits. While in and of itself this is not “wrong”, we wouldn’t expect the market to plainly follow established patterns to the T. There’s a well known axiom on Wall Street that says “the market moves in such a way as to cause the largest losses to the most investors”. What would be such a scenario right now, for short term traders? We could envision the following:
Traders SELL now, expecting a large pullback
The markets go higher, creating FOMO and an opportunity cost for not remaining invested
Traders BUY back at higher prices due to belief that “trend following” is back
Markets then go lower than they are today, with SPY closing the gap at $440, proving that selling was indeed the wise decision to begin with
We want to avoid this dynamic. As such, we will slowly scale out of positions that have reached their fundamental price targets. As a replacement to these positions, we will add to short term treasuries and broad market ETFs with as little technical downside as possible. Another trade idea for those wishing to pursue hedging to a certain degree is to sell calls on existing investments (covered calls). That way, a bit of extra upside is captured through gaining the option’s premium.
Overbought conditions have first surfaced Friday, December 01. On average, conditions persist for about 10-15 calendar days. All selling and rebalancing should be complete by December 10 - 15, on expectations that a better entry point will eventually arrive. Expect a couple of Trade Alert emails in the following period.
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!