Weekly Preview / July 05
Notable Events on our Weekly Watchlist:
Monday: N/A
Tuesday: N/A
Wednesday: ISM Non-Manufacturing PMI, JOLTS Job Openings, FOMC Minutes
Thursday: ADP Employment Change, Balance of Trade, Initial Jobless Claims
Friday: Unemployment Rate, Non Farm Payrolls
ETFs to watch: TLT, SPY, XLE, DBC
Last week ended somewhat on a high note in equity markets, as stocks showed resilience in front of bad news. Our only explanation lies in the speculation from investors that signs of slowing economic activity will determine the Fed to at least “take the foot off the gas” in terms of rate hikes. This was most obvious in two episodes that we would like to highlight from last week: the price action in treasuries and the intra-day rally on Friday after Atlanta FED released their latest GDPNow Q2 Estimate at -2.1%, confirming we are in a technical recession. This announcement gave a boost to the SPY of about 1.3%, clearly signaling a “bad news is good news mentality”. Let’s explore where that leaves us, and where we think we’ll go from here.
TLT Analysis
As mentioned repeatedly in our “Commentary” section, we like the technical setup TLT is forming here. Unlike stocks, treasuries have limited room to fall, as a drop in price automatically means higher interest rates. In a credit-based economy, higher rates will kill economic expansion, so there is a “hard cap” on where rates can rise. We will explore the fundamental reason for owning bonds in a following article, but for now, let’s focus on the technical setup.
As isolated by our methodology, TLT is forming a negative long-term technical channel and has broken above the lower trend-line with positive medium term momentum. A successful retest of trend-line support has occurred on June 28 and since then we have only seen treasuries rally toward resistance at the 50-day moving average (green line). It remains to be seen if the rally will continue above the 50-day, but TLT is not yet overbought (scoring 66/100 on this metric). We will start initiating a 15% core position in the Sigma Portfolio while the price stays in the 110-122 range, buying any dips that do not violate support. The idea is to front run our own system (and other trend following models) that will start to heavily allocate toward bonds somewhere above the 122 level (yellow line).
SPY Analysis
Since peaking in early January, SPY has been mostly confined to a narrow technical downtrend. While the long-term technical channel is still positive, SPY is now sitting at -1.82 standard deviation distance from the regression line (also called Z-Score). This is way below our stop level of Z-Score -1.0 which coincides with the lower trend-line and is the main reason automated strategies are no longer including equities in portfolios. We’ve seen (and traded) a short term bounce from the isolated support level of 369. Theoretically, this so called “bear market rally” can reach the 409 area (yellow line, close to short term channel). In our view, equities are not oversold right now, but sentiment is dire. Stocks tend not to crash when sentiment is this pessimistic. I suspect we’ll see more short term upside in equities for the following two weeks, up to the start of Q2 earnings season. The game plan right now is to stay neutral, as the risk-reward balance is not in clear favor of either bulls nor bears. We are looking at a period of range-bound trading, rather than trend-following.
In the eventuality we reach the 409 level, we will open select short positions, according to our Sector Analysis (consumer discretionary companies are vulnerable, for example). The stop (for shorts) would be around SPY 419. Conversely, if the market goes lower from here, in “extreme oversold mode”, we will target a level below 369 for a possible reversal and establishing long positions. Either way, it’s just a trade for now.
Market Breadth Analysis
We are focusing on the Market Internals > Overbought/Oversold instrument as it has been the best at calling out significant pivot points in the market. The past week, we have witnessed an improvement in the overall score, but conviction is lacking. Stocks are no longer oversold, and just 220 of top volume issues are sitting above their 200-day moving average. This deteriorating environment is making us weary of trying to call a bottom at this juncture. We would need to see continued strength in terms of Stocks Overbought (lower histogram, orange, deteriorating) v.s. Stocks Oversold (lower histogram, grey, spiking higher). We are also watching the overall reaction to earnings, as valuations might get re-adjusted, from an E point of view - so far, just the P in P/E has shown weakness. Earnings are yet to revert (see Market Fundamentals).
XLE Analysis
We are continuing to focus on XLE in our Weekly Preview article because it is one of the only two sectors of the equity market with positive 6 month returns. XLE has taken a beating as of late, with a 21% plunge form recent highs. This haircut has put it firmly in Oversold territory (13/100 score), yet we find it to be reasonably priced within its long term technical channel, with a Z-Score of -0.29. I would rate XLE as a buy at these levels, with technical near-term support, at 68.25. The 200-day Moving Average also resides within close distance of that level, so my thinking goes that we will see continued weakness near term in XLE, while the inversely correlated market (every other sector basically) will grind higher. If inflation keeps up, positions in energy will provide a nice hedge.
Takeaway:
A short term rally might have more to go, with equities proving resilient in the face of grim economic forecasts. Investors are betting the Fed will bail them out again and are starting to price in rate cuts in 2023. We take a neutral stance on equities as of this writing and prefer to look at treasuries as our next core position for the second half of 2023. Bonds simply offer a much better technical and fundamental risk-reward proposition at this juncture.
Andrei Sota