Notable Events on our Weekly Watchlist:

Monday: Consumer Inflation Expectations

Earnings: ORCL, COUP

Tuesday: Inflation Rate

Earnings: N/A

Wednesday: Fed Interest Rate Decision

Earnings: LEN

Thursday: ECB Interest Rate Decision

Earnings: N/A

Friday: N/A

Earnings: DRI

ETFs to watch: SPY, TLT, QQQ

Pressure is building for the bulls ahead of Inflation Report & Fed Decision

Last week, we wrote that SPY successfully tested the 200-day Moving Average. This made the bulls come up with all sorts of justifications for such an apparently important technical move, and we noted that’s it was in no way significant. Our point was validated this past week, when the market simply failed to hold support, and drifted lower on the very robust jobs report from the previous Friday.

Nick Timaros from the Wall Street Journal (nicknamed “the Fed whisperer” since his writing is considered to be a back-channel for the Fed’s communication) recently penned the following:

The hawkish language was enough to unravel the bullish case in the short term and pressure the market into a more defensive posture ahead of Tuesday’s Inflation Report. The near-term upside is almost identical to the downside according to our technical analysis.

SPY Analysis

The market is no longer overbought, but with a score of 68 / 100, it is far from oversold as well. The MACD indicator has turned negative, which signals the buildup in selling pressure and waning momentum from the recent rally.

Another very important technical development that we would like to point out is the recent transition to a Down-Trend for SPY (meaning that the technical channel featured on all of our charts is now creating a negative slope). This is the first time we have recorded a negative transition in the last 10 years - such a change requires not only a significant drawdown to occur, but also a large amount of time to pass without recovering to the previous trend. The SPY has not reached a new all-time high in 236 trading days.

This change will affect the portfolio allocation logic of our strategies, as well as the placement of levels on our technical analysis chart. A Down-Trending channel slope usually precedes an official bear market.

With trading volumes unable to sustain the recent advance (Market Internals / Volume), excitement for the rally has fizzled over the past week. The Fed is reducing market liquidity month after month, and acting as a drain for excess cash.

The good news is that sentiment (measured with our Market Internals Overbought / Oversold indicator) is no longer at an extreme high reading. The Market’s overall score at 58 is lower than the SPY’s at 68, meaning that the decline of the average stock has been more pronounced than the benchmark index itself.

This leads us to conclude that the market’s positioning ahead of the Inflation Report is more balanced, but still tilted toward the bullish side. Just not in an extreme way, like before.

What are bonds telling us?

While the media’s attention is focused on stocks, another bullish surge has happened in treasuries at the long end of the curve. What is more surprising here is that TLT has begun to act in a disconnected fashion to SPY. We are watching for a break in correlation for these two instruments, as that would indicate a “flight to safety” trade is taking place. If SPY is heading lower on growth concerns, and TLT goes higher at the same time, that is an unmistakable message of a recession being priced in.

If any rally is to be chased, we would prefer to chase the rally in treasuries.

So far, the surge in TLT has stopped short of the M-Trend level (required to be surpassed to mark a reversal of the current Down-Trend) and the instrument is heavily overbought and extended currently. We would like to see a consolidation occur first, before proclaiming that the bear market in treasuries is truly over. A word of warning - if higher rates are going to be priced in (as Nick’s writing suggests) this will send treasuries lower first, not higher.

Most likely, the current rally in bonds is fueled by year-end rebalancing in large portfolios. We should probably expect a pullback in treasuries, as these flows fade, and identify a better entry point in Q1 2023. Patience is required here as well.

Takeaway

Risks are currently tilted towards weaker economic outcomes, given the Fed’s ongoing monetary tightening. Treasuries are lining up to become a preferred asset class to equities in 2023 based on the risk-reward offered. However, neither market is currently a bargain, due to the Dollar’s recent depreciation and negative correlation to everything else.

Tomorrow’s CPI report could send the market either way short term, but risks are high of a disappointing result (a still strong labor market makes inflation hard to cool off, but normalized energy prices could provide relief). We’ll need to wait and see. At this stage, the market will tell us what the next move should be.

There is no particular trading planned in the Sigma Portfolio for now, but a break higher or lower would make us reconsider positioning accordingly.

Andrei Sota