Weekly Preview / June 21
Notable Events on our Weekly Watchlist:
Monday: NA
Tuesday: Existing Home Sales
Wednesday: Powell’s Testimony; Consumer Confidence (Flash)
Thursday: Initial Jobless Claims, Powell’s Testimony
Friday: New Home Sales; Michigan Inflation Expectations
ETFs to watch: SPY, TLT, XLE
Coming on the heels of a dreadful trading week, where major averages finished down between -4.8% (DOW, Nasdaq) and -5.8% (SPY), both sentiment and positioning echo extreme oversold levels on virtually every measure. You can clearly understand the record bearishness level by taking a look at the market breadth analysis below, but there really is no shortage of indicators, charts and analysis that are simply at extreme low levels. Moreover, during the weekend, crypto markets came under tremendous pressure, with Bitcoin breaking the psychological 20k level to trade down to 17.744 on Saturday. It has since recovered, but some view it as an ominous signal nonetheless. This week we will get Home Sales data, preliminary info on the labour market, inflation expectations and Powell’s testimony. Given the reaction to the Fed Chair’s comments last week, we are left to wonder if he will soothe the equity markets in any way by at least mentioning the Fed’s third directive - “market stability”.
Market Breadth Analysis
The number of oversold stocks has reached 800 out of 1000 last week. This is a record for the past 2 years and pushing above 2 standard deviations. In other words, we are firmly sitting in tail-event land. Just 4 stocks out of 1000 are considered overbought at this point. The transition from bull to bear market is visible by tracking the 2 std dev Oversold grey line move above the 2 std dev Overbought orange line. A slow-motion development for sure, but one that is happening nonetheless. As far as technical analysis on our Overbought/Oversold market oscilator goes, we are sitting at the lower end of the channel. A rebound in this metric would take our oscilator to the 45-50 area, and so far this has proven to be a reliable instrument to track bear-market rallies.
SPY Analysis
Our previous SPY analysis laid out two probable scenarios.
The break below support (408) led to the current outcome.
SPY closed just above our technical support level of 365.03. We can use this level as a stop-loss for a speculative net-long position on the thesis that the extreme oversold conditions will revert at least in the short term. Target for the rally is the previous support level of 408.93, now turned resistance (or 45-50 area in the Market Breadth oscillator, whichever comes first). I would prefer using options for this trade rather than an outright long position due to better drawdown protection in the case that the movement fades).
Sectors
All sectors of the market are deeply oversold, as measured by extensions below their 200, 50, 20 day moving averages. The only sector trading above its 200-day MA is Energy (XLE). We will get to that in a bit, but for now, note the respective Absolute and Relative Z-Scores for the sectors. I have highlighted the relative out-performers with the green rectangle and the relative under-performers with the red. We generally suggest using weakness to add to outperforming sectors if you're so inclined, and selling the under-performers on strength. We currently don't see a full market rotation in the works.
XLE Analysis
Energy has been an excellent investment so far this year. XLE shows strong momentum, but it has been a very crowded trade, along with commodities. This has made the position vulnerable to a strong pullback, and that came with a vengeance last week. XLE broke through multiple levels of support and unless a reversion occurs early in the week, we see a high probability of continued weakness (to 67, next support). Relative to SPY, XLE's performance is not oversold by any measure, so there is room for further downside. This will most likely coincide with continued pressure in the commodities space, and a short term pullback will give inflation-sensitive sectors a boost (and by that we mean almost the whole market at this point). A short XLE long SPY trade could work for now.
Market Fundamentals
Our new instrument aims to give you a long term view of S&P 500 equity valuation, EPS, sales growth and margins. These are calculated after companies report them, at the end of every week, so metrics are not forward looking. Instead, look to this analysis to understand where we are in the current business cycle. We have chosen to show P/E ratios, as these are representative for long-term returns. Right now, we see PE's at median levels for the last 10 years. One can make the case these are close to fair value in the current environment. We are still waiting for EPS to revert lower, and for margins to come down significantly. How valuations will respond to next quarter's reports will be key in determining if this bear market has more to go.
Takeaway:
Short to intermediate term we see extreme oversold conditions fueling a rally or consolidation at current levels. Slight rotation might occur from XLE to everything else. Short positions have little upside left at this point.
On a longer term horizon, valuations are starting to look appealing. A series of quality long positions can be initiated here. Short term gains should be hedged however, as this market still looks frothy to us, with many speculators still trying to buy a bottom. Instead patience is required and our strategy requires moving slowly.
Andrei Sota