Notable Events on our Weekly Watchlist:

Monday: Markets Closed

Earnings: N/A

Tuesday: China GDP Growth

Earnings: GS, IBKR, MS, PRGS, UAL

Wednesday: Retail Sales, PPI

Earnings: KMI, AA, SCHW, PNC, PLD, WTFC

Thursday: Building Permits, Initial Jobless Claims

Earnings: NFLX, AAL, FAST, PG, TFC

Friday: N/A

Earnings: ALLY, SLB, STT

ETFs to watch: SPY, XLF, XTN

The Bulls, The Bears and The Fed

Last week was certainly eventful, with a flurry of trade alerts for the Sigma Portfolio - we shifted 32% of allocation in just a couple of days, out of cash and into treasuries and equities (via closing hedges mostly). This came on the heels of a series of bullish technical developments for the market, and in recognition of a CPI print that was just right: not to cool, not too hot.

Bulls are buying stocks regardless of positive or negative economic data. There always appears to be a justification for getting long the market. While there is some truth to the optimistic narrative, risks are starting to pop up as well. We’ll take a look at both sides and conclude where the balance lies. For now, the “pain trade” (where most investors lose in the short term) appears to be higher.

A Flimsy Statistic to be Aware of

We found an interesting piece of statistic, published by Carson Research: since 1950, with stocks down the previous year, if the “Santa Claus Rally”, the first 5 trading days of January and the whole month of January itself are positive, then the returns for the full year are ALWAYS positive. Positive by a wide margin (28.9% median gain for the SPY).

While January is far from over (bookmark $382.43 as the starting price for the calculation), the Santa Claus Rally itself only turned positive in the last 10 minutes of trading on January 2nd. That is why we called this statistic “flimsy” at best. It does raise one very important point though: if bears are wrong, they might get badly burnt in 2023.

Getting into more serious and reliable analysis, we find SPY at a crossroads, pushing up against heavy technical resistance.

SPY Analysis

While many armchair analysts will focus on the 200-day Moving Average, we have actually excluded it from our view. Yes, SPY is trading above it, but it is hardly relevant right now. What is important to note is the confluence of the S1 Level (398), the trend-line that sits just above (403.6) and the M-Trend Level (404); this cluster of resistance forms the “neckline” of the inverse “head and shoulders” pattern that has formed recently (yellow highlights). A convincing break above this level would set us up for a very bullish continuation.

But there is a lot of work to be done until we get there. As has happened previously, market breadth (Market Internals, Overbought/Oversold) is getting close to extreme. Any further push higher will take our indicator past the 2-Standard Deviations band, a place that has previously been an excellent opportunity to hedge or reduce exposure (August, November 2022).

This conundrum will be resolved by waiting for the following set-up: the market needs to get Oversold AND still be able to hold the M-Trend Level (now $404) as support. Once previous resistance turns into support, we can give the all clear to invest. Until then, we can only trade and speculate.

FYI, this kind of breakout has been confirmed in long term government bonds (TLT). As you can see below, the M-Trend Level was crossed to the upside twice. The first time around, the ETF was too overbought for our system to register any kind of BUY SIGNAL. The second time, however, a positive MACD cross occurred, and all of our models got allocated to bonds.

It was a real shame that the very next day, TLT closed a smidge lower than the M-Trend Level, which acts as a STOP LOSS. This determined Enterprise and Nostromo to close the position immediately, the following day. Rules are rules, and they are intended to keep us out of trouble when trading an instrument entrenched in a bear market.

For SPY, the improving technicals, positive MACD Signal and the fact that overbought levels are not yet extreme suggests that there is room for further upside. Importantly, this breakout has not yet happened, it is merely more probable at this point.

The Fed is the real risk

Low interest rates have been the main reason for equity investors to push prices (and valuations) ever higher for the past decade. As interest rates have recently surged, valuations have corrected. Some investors are saying this correction has run its course and now is a good time to pick up risk exposure cheaply.

Our instrument (Market Fundamentals, P/E Ratio) measures the average valuation for S&P500 companies starting in 2010 up to the present. While it’s certainly true that valuations have come down markedly from their 2021 peak, any number above 20x earnings is not exactly “cheap”. We’re currently near the bull market median of 22.5.

Simply put, if interest rates are to stand at 5% (as the Central Bank suggests will happen), these levels of valuations are not sustainable. Bonds would offer a much better risk/return ratio than equities and investors would prefer them.

If the economy does achieve a "soft landing" and inflation remains at target levels, the Federal Reserve will likely keep interest rates at their current level and continue reducing its balance sheet, instead of cutting rates or implementing quantitative easing measures. With a stable economy and rising stock market, why would the Central Bank loosen financial conditions?

Don’t be surprised to hear hawkish rhetoric like the statement above from Richard Clarida every time the market gets hot. The Fed’s goal is to slowly grind the market lower and not cause an outright crash. They would prefer a stable but slow economy where they maintain credibility rather than a hot economy where they possess none.

Takeaway

From an asset allocation standpoint, we are equity-risk neutral and long bonds. Our cash weighting is at very high levels and as the dollar continues its meltdown we will be looking for areas to diversify into. Otherwise, we risk to underperform badly in the Sigma Portfolio.

A break above $404 for SPY could signal a trading opportunity as long as the MACD signal remains positive. This would be “just a trade” for the moment, and not a more permanent fixture. We could potentially start initiating longer-term positions if the market manages to hold recent support from an oversold state.

We are also keeping an eye on volume to determine where the current rally might run out of steam. In the event the breakout fails, we will add hedges on a negative MACD crossover.

As the market sits at this important juncture, the battle between the bulls, the bears and the Fed will be decided by next week.

Andrei Sota