Bullish Momentum Remains Intact

Over the past week, in our Briefings and Newsletters, we’ve discussed the need for a correction in the equity market, given the extremely optimistic expectations currently baked into stock prices. On Wednesday, we got that correction courtesy of Jerome Powell’s speech and lackluster earnings from Google and Apple.

However, that drawdown did not last long. Great results from Amazon and Meta plus a stellar employment report on Friday sent the market surging again toward all-time highs. Wednesday’s selloff successfully tested the 20-DMA and opened a window for buyers to step in, confirming the bullish momentum as intact (during substantial bullish advances, there are only limited windows of opportunity to increase equity exposure - see the whole of 2017). However, there is such a thing as “fair value” which acts like “gravity” sooner or later for stock prices. And right now, even accounting for a more optimistic scenario, we are trading WAY above fair value.

As shown below, the current rush to bid up stocks looks and feels very similar to other episodes in March and July last year. At that time, a similar bullish psychology was pervasive, as investors were aggressively buying into the A.I. hype (while the rest of the market dragged). During each episode, the feeling was that “stocks only go up”, as prices advanced in a seemingly unstoppable fashion. Of course, markets eventually corrected, including a very nasty 10% drawdown in October, in which bears came out of the woodwork to proclaim “doom and gloom” all over. The latest advance leaves the market wide open to such a correction in the coming months.

If we account for a median price target of $508 for FY 2024, this leaves year-end upside at a whopping $544 for SPY (1 standard deviation above $508). Not even the most optimistic analyst on Wall Street has that target. Working back from $544 to the present day, along a 12% compound annual growth rate channel slope, we get to $499, as the near-term upside for the advance (granted - we are almost already there). That’s an additional +0.94% upside. Meanwhile, the closest significant support level (R2 and the 50-DMA) sits at $472, some -4.52% lower. This is a terrible risk-reward proposition, and speaks to the extent that “good news” has already been priced in.

However, SPY is increasingly not representative of the broad market (as 30%+ of the S&P 500 benchmark is made up of just 10 stocks). If we look at something like the iShares Russell 2000 ETF (IWM), then it becomes clear that the market is less enthusiastic. Yes, small caps are trading in the upper bound of their recent range, but they’ve been going nowhere for the past 2 years. Small caps get a valuation penalty due to being far more economically sensitive to an eventual recession than their large-cap counterparts.

There’s little reason to be worried about the overall market right now, but the only justification for piling into equities at this stage is the hope of selling to a “greater fool” - otherwise known as trend following or momentum as far as strategy names are concerned.

As our Market Fundamentals instrument shows, valuations have become completely detached from cycle averages. Can valuations go even higher? Of course they can (as they have, in the post covid 0% interest environment). But what we’re seeing here is that investors are not getting a particularly good deal.

This market is being held up by relatively high levels of liquidity, which is a near-term bullish indicator (higher prices on higher volume is good). Coupled with limited drawdowns and a depressed VIX index, trend following models are right to keep doing what they’re doing and “buy the dip”. It all works great until it doesn’t, and the only way to limit the losses of these systems is to implement stop levels. When these levels are hit, the same move happens in reverse and indiscriminate buying turns to indiscriminate selling. Just look at Chinese small caps (ECNS), which are going through a complete meltdown right now, following a +84% post covid rally.

Nevertheless, U.S. equities are not directly comparable to Chinese ones, and there’s little indication that such a scenario could unfold in the U.S.; Investor psychology is comparable, however, and in China we are currently witnessing a liquidation event - trend following in the opposite direction.

All of the technically strong measures in the U.S. markets simply fly in the face of broad economic fundamentals. In theory, the stock market should correlate with confidence, consumption, and economic growth. The financial market is expected to lead the economy by about 6 months, as investors are able to digest and react to data in real time. One of the best resources for measuring economic strength is the Conference Board’s Leading Economic Index (LEI). The composite economic indexes are the key elements in an analytic system designed to signal peaks and troughs in the business cycle.

According to the latest reading, the US LEI fell slightly in December, continuing to signal underlying weakness in the US economy.

A breakdown of the LEI’s components reveals weakness in most indicators…

..while the 6 month growth rate of the LEI continues to signal recession, despite the recent up-swing.

So where does that leave us, as investors? On one hand, portfolios should be doing all right. Millennium Alpha has recently lodged another all-time-high during live-trading, courtesy of holding META in its portfolio. This strategy is now up 23.1% since being published on our website. This is of course, great news, but it does come at the cost of unfavorable near term risk-reward going forward.

Our Trading Strategy

We will pursue a growth to value rotation in our next rebalancing routines. We’ve been positioned very well for the current advance in the past, but as we go forward, there is limited upside to be had. Rather than reducing equity exposure outright, we’d simply pivot to less volatile, more defensive stocks (the opposite of NVDA for example). Keeping some cash on the sidelines (or tied up in short-term bond funds) is also a viable option. We’d like to ride the current bullish momentum wave for all it’s worth, but experience has taught us that reversions, when they do occur, are brutal and unforgiving. Month-long gains can be wiped in weeks.

The only way to defend our portfolios from such a scenario is to take pre-emptive action. So that will come into focus going forward, as we rotate exposure from high-beta, high growth names to lower-beta, more value oriented picks. The coming week is light on the economic data release front, but plenty of earnings are left on the docket. Although it has to be said that once all of the “magnificent 7” stocks have reported, interest in the earnings season will take a back seat to Fed policymaking, geopolitics and technicals.

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!