Weekly Preview / March 06
Notable Events on our Weekly Watchlist:
Monday: N/A
Earnings: RIDE, WW
Tuesday: Powell Testimony
Earnings: DKS, CRWD, SQSP, SUMO, THO
Wednesday: JOLTS Job Openings / Quits, Powell Testimony
Earnings: CPB, BF.B, MDB
Thursday: China Inflation
Earnings: ULTA, DOCU, FIZZ, MTN
Friday: Non-Farm Payrolls, Unemployment Rate
Earnings: N/A
ETFs to watch: SPY, TLT
Dip gets bought, but correction persists
Before getting into this week’s newsletter, we’d like to announce the availability of the new Valuation Wizard Instrument! This tool allows you to input your assumptions about a company’s growth prospects and outputs a fundamental Price Target and EPS Growth Rate by creating a DCF Model for you.
These results can be then used in conjunction with our Technical Analysis Instrument, to view the results on a chart. You can find the new instrument under Fundamental Analysis. The Fundamentals Explorer Instrument has also been optimized for speed and now works 10x faster.
Last week, we warned that a break of support would coincide with a bear-market rally confirmation. The market has indeed declined to and successfully tested our designated level, after which it promptly bounced at the end of the week, with 2 days of strong performance. That performance had all the marks of a short-covering rally, but it does keep the bulls in the game for now. Trend-following systems are back to buying dips, and coupled with strong seasonal performance in March, we could see some technical upside to $430.
Of course, the price action comes in direct contradiction to fundamental factors such as earnings and valuations, which still suggest caution is warranted. However, we must respect this price action until it changes.
SPY Analysis
The MACD Signal is starting to reverse, albeit from a higher level than previous turns (levels marked with dotted lines).
Dollar Transaction Volume is NOT confirming the bounce. We are inclined to interpret this data as short sellers or speculators “playing” this technical move, not strong demand from investors initiating new long positions.
Bond returns still highly correlated with stocks
The chart above illustrates a very pertinent point to the current market environment: a combination of high growth ETFs (ARKK, IVW, QQQ, in orange, equally weighted) are trading in a very similar fashion to TLT (white). This makes sense from the perspective of them being “long duration assets”. But in terms of safety of principal, there is a huge differential. High growth companies could go bust in an economic downturn (or dilute shareholders very much in the process of staying afloat), while the U.S. will never default on its bonds.
The fact that we are still not seeing a disconnect in this pair of assets tells us the risk-taking mentality of investors is alive and well. There is no “flight to safety” trade yet, where bonds would rise and stocks would fall (along with yields). Until we see such a disconnect, we are still in the “denial” phase of the bear market.
Speaking of which, the “Fed Pivot” narrative is finally priced out of 2023:
Pricing for the December 2023 Fed Fund Futures contract is now attributing the highest odds to a 525-550 bps rate (also regarded as the “Terminal Rate” at this point), and no rate cuts until March 2024.
Despite a higher terminal rate priced in (this used to be 4.9% a month ago), short term bonds seem to have bottomed. Shown in the chart below is SHY, comprised of 1-3 year maturity bonds, most sensitive to Fed policy.
The signal that the bond market is sending is that earnings growth will ultimately disappoint. Investors are happy to cash in the relatively high yield from short term treasuries rather than bet on the EPS outlook of stocks, despite inflationary pressures.
As more Q4 results get updated in our database, it’s clear to see that the tide is turning in the Earnings Cycle. Charting a regression through the last 5 years in terms of EPS for the top 500 US companies results in an upward sloping cyclical movement. EPS is always upward sloping due to inflation and the tendency for companies to keep up with it longer term. Cycles are due to the nature of profit margins, which are highly mean reverting.
The ideal moment to start investing from this standpoint is when the cycle is halfway through (between the yellow and grey solid lines in the middle of the channel). Stocks start doing well ahead of EPS bottoming, so there is no need to actually wait for that moment. But it still seems we are 1-2 quarters away from the middle of the cycle.
Takeaway
Volume tells us this is a short covering rally.
We need to respect the near term price action for the moment. If we get a BUY signal on SPY, above support, we will close our hedge (which will increase overall equity exposure). If and when we get to technical resistance (417-430), it will be time to re-initiate that hedge. Overall exposure will follow the guidelines from our automated models.
We will also rotate to shorter term treasuries on a stocks + bonds rally, as long-term bonds are still highly correlated to growth stocks. When that correlation breaks, it will be time to allocate more heavily to long-term bonds again.
Powell’s testimony is coming up this week and could shake up the market a bit. The next Fed meeting is scheduled for March 22 and there is a not insignificant chance of a 50bps hike (30% odds). This kind of uncertainty is atypical for the next scheduled meeting, where the move is telegraphed with near certainty.
Andrei Sota