Notable Events on our Weekly Watchlist:

Monday: Market is closed.

Tuesday: N/A

Earnings: HD, WMT, CWH, KEYS, MELI, PANW, PSA

Wednesday: FOMC Minutes

Earnings: NVDA, BIDU, EBAY, ETSY, MAXR, NTAP, PXD, TDOC

Thursday: Initial Jobless Claims

Earnings: BABA, AMT, ADSK, SQ, BKNG, CVNA, DPZ, FTCH, INTU, W

Friday: Personal Income / Spending, Inflation Expectations

Earnings: N/A

ETFs to watch: SPY, XLY, XLK

Mean Reversion and the bull’s hope for Trend Continuation

There are two mutually exclusive principles when trying to predict the future path for any kind of asset: mean-reversion and trend continuation. In market parlance, they are also known as “range bound trading” and “momentum trading / trend following”. You cannot apply both, when dealing with the same asset.

In today’s article, we will explore when and how to use each principle to it’s full potential, as well as the bull’s hopes that the trend will continue to support a more optimistic narrative.

But first, let’s review last week’s price action and see where we currently stand. As discussed previously we were waiting for a consolidation / sell signal in the market to trigger first, before attempting to “buy the dip” above support. That dip finally arrived, but not before “fooling” our systems into buying at the wrong time, courtesy of a very shallow MACD crossover.

The type of sell signal that we were looking for generally takes more time to develop and is considerably deeper than what we witnessed last week. As a consequence, we did not execute our strategies trade in real life, but we may consider doing that in the near future, depending on whether support holds.

The bullish bias remains in place this week, despite the selling pressure. If the market can hold support at SPY $395-$400, that will be our cue to increase exposure.

SPY Analysis

Note the environment marked up on the chart. As of November - December 2022, we have begun trading in a Mean-Reversion type environment, defined by a clear range, where it was profitable to buy at relative lows and sell at relative highs. Trend continuation strategies, that attempt to buy breakouts and “run away” with the price, have failed miserably. They have been trapped in repeated “bear market rallies”, bought the top and eventually got stopped out of their positions.

Signal Sigma strategies apply the trend following principle 100% of the time. The logic behind this choice is that for the most part, equities and most other assets spend their time in bull markets (vs cash). Trend following only works on the long side, and is therefore the strategy of choice for the bulls.

Mean-Reversion on the other hand, works best in bear markets, or direction-less assets (like certain FX pairs). It benefits by exploiting price extremes and liquidity gaps. A healthy bull market will never be “range-bound”, as prices will hover at relatively high levels, and keep pushing higher.

In order to profit from the current set-up, we must understand what environment we are trading in, and what it means from a fundamental perspective. We are armed with the tools to trade both.

Right now, the bullish case is based on a “no landing” scenario, where the economy avoids a recession, and earnings start growing again. From a technical perspective, the price action (if constructive) would represent a clear break away from the “Mean-Reversion Environment”, as it would not be profitable to sell at this juncture. We’ll update the chart, according to this scenario, that sets a fundamental Price Target for SPY at $435 (6.7% upside from current close price, $405.7 current fair value).

Recent upbeat economic data has been supportive of this scenario, and currently this is what the market is pricing in. In order to obtain a 1-year average performance for stocks of 8%, we would need to buy SPY at 402.7 and keep our fingers crossed for “no recession”.

The set-up that I just described is precarious, at best, for 2 reasons.

The Fundamental Problem with the Bullish Case

This scenario conflicts directly with the Federal Reserve’s actions and historical outcomes of those actions. The Fed is focused on slowing inflation by reducing demand. Most of the interest rate hikes have not have time to impact the economy and show up in the data (we are barely at the 1-year anniversary of the first 0.25 bps rate hike in the cycle in March). Recession has always followed periods of inflation higher than 5%.

The optimistic answer to the points above is the elusive “Fed Pivot”.

Following last week’s inflation release, the terminal rate shifted higher, but the overall curve still shows an expectation for aggressive easing in the back half of 2023 and 2024 (the Pivot). This projected easing cycle will not come “cheap” however. Consider the following:

1. If the market advances and the economy avoids recession, why would the Fed cut rates?

2. What is the reason the Fed would stop reducing its balance sheet?

3. What kind of “financial event” would require monetary policy easing in order to mitigate risks?

Answer: there would be no good reason for the Fed to cut. They will only ease policy in the event of market instability, recession, or a default cascade. None of these are positive bullish catalysts.

The Technical Problem with the Bullish Case

For the moment, technicals are supportive for the “no recession” scenario. However, if this period of selling pressure even slightly exceeds support limits, we will soon be trading in a "Mean-Reversion” environment, which puts the bearish case back on the table.

Of course, our automated strategies will get stopped out (again), in this case, for good reason. A soft recession scenario would imply a valuation target of 17x $203 EPS, which takes SPY to $345 by year-end (a 15% downside).

Buying equities in this scenario makes sense at the lower end of the range.

Our (Market Internals, Overbought/Oversold) comes in very handy during these periods. We need to simply disregard our emotions, and trade at market extremes.

Dollar Transaction Volume has dropped significantly last week, but we are yet to see the effects of lower liquidity in volatility metrics. Keep an eye on this metric as well.

Bonds as an alternative

As discussed in our fundamental valuation article, a very problematic situation for equity investors is the risk-free yields that treasuries currently earn. The 1 Year Treasury Rate is at 5.00% currently. Why would investors risk their capital and bet on a “no recession” outcome, yet be rewarded with just 6.7% of potential appreciation?

Logic dictates that bonds are an attractive alternative, especially since they have gone through a lengthy bear market (and by many measures are still in one). There are 3 bond classes that are worthy of our attention.

Short Maturity Bonds 1-3 years (SHY ETF, 4.35% Yield)

Sitting right above the M-Trend level, SHY is coming out of oversold conditions, and appearing to break out of its bear market trend. With a very attractive effective yield, this bond class is one that we are watching for addition to the Sigma Portfolio. Statistical downside is limited to -0.24% according to our Risk Explorer, making this a very safe play.

Long Maturity Bonds 20+ years (TLT ETF, 3.81% yield)

Long maturity bonds carry a lower yield than the short-maturity ones due to the yield-curve inversion phenomenon, and are currently not oversold. Our systems (that are trend-following in nature) entered this position at a short term top, and got stopped out last week. This is a technical precaution that limits exposure to down-trending instruments below the M-Trend level. When the environment favors a “mean-reverting” approach, our system zigs instead of zagging and generates losses. In our real-life portfolio, we will be buyers of bonds, even at lower levels, due to the much better fundamental nature of these instruments.

Interest rates can’t stay this high forever, and for one reason or another, the Fed will eventually pivot and catapult treasuries higher. Meanwhile, we get paid for waiting, without the risk of being net-short equities.

Corporate High Yield Bonds, 4 years (HYG ETF, 7.72% Yield)

High Yield bonds, also known as “Junk bonds” or “Non-investment grade bonds” are a speculative play on the credit market, with the added yield derived from default risk. At a 7.72% effective yield, this bond class offers more upside than SPY, but carries increased risk over treasuries as well. In the event of a recession, this ETF will come under pressure, while treasuries will increase in value. HYG is currently part of out portfolio at a 4% weight, but we will honor stop losses here if it comes to that.

Takeaway - Bullish until proven wrong

The point of our bond class analysis is to show that there are real alternatives to generating portfolio income, without the unnecessary risk of owning equities outright at current prices. We are now at a juncture where a very fragile rally in stocks is breaking out of the downtrend pattern. This rally still needs to prove itself, by successfully testing support.

We will be adding SHY and TLT to our portfolio on their respective BUY signals, and overweight bonds in our allocation. HYG is a bond class more correlated with equities (beta-to-SPY of 0.45), and SPY would offer more upside if bought at the right price. We are waiting for that consolidation to complete and a BUY signal for SPY as well, in order to better align the Sigma Portfolio to our models.

You may have noticed that “news” and “opinions” are not part of our Process. Price action is, however, and we need to respect the overall direction of the market. We are neither bullish nor bearish, as “picking a side” will muddle our decision-making.

Currently, bulls are hopeful the Fed can avoid steering the economy into a recession. We need to respect the positive market breadth and the price breakout and add equity exposure on a pullback. Our opinion is that ultimately, this rally effort will fail, and we will get stopped out of our equities position.

Such dichotomies are part of why it is more important to have a process and follow it with discipline, than being “right” short term. Eventually, the bear market will end, and a technical breakout will ensue. It will look (and feel) identical to what we are witnessing now.

Andrei Sota