Stocks only go up

Last week, we’ve witnessed another sizable advance across all major equity indices. The S&P 500 has officially breached the psychologically important 5.000 mark, but it was the Russell 2000 which enjoyed the biggest gain. Small caps went from strength to strength and finished the week up +3.86% versus SPY’s more modest +1.57% performance and QQQ +1.80% rise.

The current bullish enthusiasm echoes the boundless optimism we’ve last seen in the March - July period of last year, when stocks also surged around 15% without any major interruption. Such rallies that occur over a greater timeframe give investors an unusual degree of confidence and invite complacency into portfolios and outlooks - basically, everyone starts expecting that stocks will only go up. Bears evaporate. The VIX gets crushed. Price targets are raised as the long trade gets crowded. Of course, the period that immediately followed the rally into July was a nasty (but perfectly normal) -10% correction into October. The catalyst for the decline was absolutely flimsy (Fed outlook) and had more to do with high deviations and turning psychology than anything else.

So is the market flashing any warning signs right now? Or are more gains set to follow? Let’s explore…

SPY has gained +13.75% in the last 3 months, for a 64% annualized performance. Since we have no more technical upside to place on our chart, we can only leave the potential gains to our imagination. Should the benchmark ETF continue on its recent slope, it would hit $545 by March 26’th. Of course, this is highly wishful thinking, as such a slope cannot be maintained realistically for an extended period of time. Sooner or later, for a reason or another, a 4% to 5% correction (at least) will occur. Potential downside is easier to determine, with the 50-DMA and the R2 level providing support near $477 (-4.82% from the last close). We will update our fundamental analysis and Price Target with a quarterly report at the end of this month, and maybe the chart will support some additional upside. But until then, this is what we’re working with.

Momentum remains strongly positive, as SPY is both on a short and medium term BUY signal. However, the price action has now become so bullish that it’s in fact bearish. We can see this by studying the extension from SPY’s own 200-Day moving average.

Averages are called “averages” for a reason - in order to get an average for any time series, the price must oscillate both above and below the said average. Our system measures the normalized distance to each key moving average in what we’ve called a Sigma Score. A Sigma 200 Score of 0 means “the instrument is trading in line with its 200-day average”, while a score of 1 (which is maximum) means that the instrument is trading “as far away as it has historically traded above that average”. Let’s visualize the Sigma 200 Score for SPY:

There have been at least 2 previous instances in the past 2 years where we’ve seen similar large deviations from the 200-DMA. To the downside in October 2022 (where we get a -1 reading) and to the upside in July 2023 (+1 reading). Right now, the deviation reads 0.98, or 98% of the historical distance ever recorded. Note that every such episode has been followed by a multi-month counter trend “revision to the mean”. In the present case, this can only be achieved through a correctionary phase, which would actually be healthy for the overall bullish advance in 2024.

What exactly would trigger a correction and when will it occur? We can only speculate on that, but technicals are suggesting an increased chance of it happening sometime in the near future.

Furthermore, Market Internals are starting to show signs of a significant divergence. Strong momentum has only carried a particular group of stocks (mainly large cap tech and growth names), leaving everything else behind.

In their note to investors, Bloomberg notes a historical low in “everything else except tech” going back to 1999, illustrating the point we’re trying to make.

Looking at other measures and means of analysis, Sentimentrader.com also had an interesting take:

“Recently, we saw that there have been some technical warning signs on the Nasdaq. Among those are the Hindenburg Omen and Titanic Syndrome, which have been stacking up lately. If you can get past the hyperbolic names, they provide helpful insight into what’s happening below the surface of the major stock market indexes. When these signals trigger, they highlight conditions when not everything is in gear. And they’ve both been triggering consistently on the Nasdaq over the past few weeks.

During the past three weeks, the two indicators have triggered a combined eight signals. That’s the most since December 2021. We can see from the chart below that when eight or more signals were triggered, the Nasdaq Composite’s annualized return was a horrid -29.3%.“

In conclusion:

“The results were not encouraging for bulls. Across almost all time frames, the S&P’s returns were woeful, consistently negative, and with a terrible ratio of risk to reward. Buyers shrugged off the warnings in 1963 and 2017, but other than that, it was trouble.”

Identifying and acting on a turning point in the market is more art than exact science (and we are saying this from the vantage point of a quantitative data analytics platform). The signs that we’re now seeing are the equivalent of storm clouds gathering on the horizon. It doesn’t mean that a hurricane is going to hit, or that we will go to cash immediately (or… God forbid.. put on a short position!). However, the odds for the current rally to continue in the same way unabated are smaller and smaller.

We’ve covered the broad technicals, but what about the fundamentals? How are Q4 earnings stacking up?

After 2 thirds of S&P 500 companies have reported results for Q4 2023, 75% have reported actual EPS above estimates and 65% have beat revenue estimates (source). These figures are entirely expected, but they are both below the 10-year average. Revenue growth (equally weighted) is running a smidge below the cycle median, and shows no signs of turning just yet. The blended revenue growth rate (market cap weighted) for the fourth quarter is 3.9% as of today.

The good news is that EPS has stabilized over the recent quarter. In terms of sector performance, year-over-year earnings growth, was led by the Communication Services (XLC), Consumer Discretionary (XLY), Utilities (XLU), and Information Technology (XLK) sectors. On the other hand, four sectors are reporting a year-over-year decline in earnings: Energy (XLE), Materials (XLB), Health Care (XLV), and Financials (XLF).

The week ahead features a potentially volatile session on Tuesday, when the Inflation rate will be published. We’ll be looking at the reaction in the treasury market, especially at the long end of the curve. Economists are currently expecting core inflation to come in at 3.7% Year-on-Year and headline inflation at 3.1% Year-on-Year.

Currently, Fed Fund futures are pricing in 5 rate cuts for 2024, but the outlook gets muddy after the July meeting. There is significant risk interest rate traders are getting this bet wrong and will need to adjust in order to accommodate less cuts if inflation remains sticky.

We’ll be looking at the services component of inflation, and less at energy and food prices.

At the last FOMC meeting, Jerome Powell explicitly said that the Fed will be analyzing sticky price data in order to guide policy moves going forward.

Sticky Price Consumer Price Index (CPI) is calculated from a subset of goods and services included in the CPI that change price relatively infrequently. Because these goods and services change price relatively infrequently, they are thought to incorporate expectations about future inflation to a greater degree than prices that change on a more frequent basis. - Federal Reserve Bank of Atlanta

It makes sense for the FED to look more closely at this measure. So far, the trend is trending in the right way, but a reading of 4.58% in December is hardly something they are comfortable with. Judging by all of the available economic data so far, we’d label Tuesday’s inflation print as a risky one.

On Friday, Building permits and PPI will be two other key data points worth watching. Several high profile names will also be reporting results this week (Arista Networks, Cisco Systems and DraftKings among them) but the bulk of Q4 earnings are now behind us.

Our Trading Strategy

With a record number of investors chasing stocks into the stratosphere, it’s no surprise we’re starting to see some technical indicators start to turn. However, there’s no precise way to “call” a top, and it’s counterproductive to try to do so. Tops are processes, rather than “events”. Therefore, we’re not in a hurry to cut our equity exposure, but rather we’ll let the market guide us.

In the meantime, executing a sector / factor rotation and taking profits in extended positions is something that makes complete sense and it’s what portfolio management is all about. Initiating new positions, on the other hand, gets tricky here. It’s very likely we’ll get a better opportunity to increase equity exposure later this year.

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!