Cracks Start Showing Up In The Bullish Trend

The market has been trading in a well defined bullish trend since the start of the year. Violations of the 20-DMA have been few and far between during this rally, while various trendlines have defined short term tops. We are noticing a clear deceleration in the slope of these short-term trends, as well as a deterioration in the MACD and RSI signals, both of which signal a potential shift in momentum.

A clear break to the downside has not yet been established, but any weakness has the opportunity to cascade into more selling. We may be setting up for a pivotal week, with further corrective action, since investors understand stocks are stretched at this juncture. With the 20-DMA currently acting as support, any violation of this level would lead to stops-losses starting to trigger.

Upside resides at $533 (High Trend-Line, +4.54%), while support should come in right below the 20-DMA, near the late February pause and the R2 level, at around $504 (-1.14% loss).

As readers of our newsletters are well aware, we have been arguing for taking profits and reducing exposure in portfolios since late January. On some of these calls, we’ve been early (NVDA for example), on others we’ve been spot on. While it’s impossible to precisely time a market top, there are now multiple signals in place that suggest weakness is incoming. Make no mistake, this is all part of a healthy market cycle, one that bulls should welcome. We don’t know what will be the “straw that breaks the camel’s back” - that one event which ignites a reversal in sentiment. We just know that all of the conditions are there for such a reversal to occur, as exuberance .

The FOMC will be voting on monetary policy on Wednesday, and traders widely expect rates to remain unchanged (98% odds). Jerome Powell’s press conference will be carefully scrutinized for any indication of change in the Fed’s approach. There is a not small chance that the Fed won’t cut rates in June either (41% currently).

This comes at a time when both retail and professional investors are super bullish on risk assets. Active asset managers are “all-in” according to NAAIM, as the exposure number exceeds 100.

And, in the most recent AAII Sentiment Survey, the bull-bear spread continues to remain highly elevated (now 24%, vs 6.5% historical average).

The consensus assumption behind the surge in sentiment is not only the avoidance of a recession in the US, but accelerating EPS growth for corporations. As we’ve previously reported, the Conference Board has abandoned its recession call, fitting the narrative to a T. Corporate America is also no longer concerned about an economic slowdown, as the word “recession” was cited in only 47 earning calls during the last quarter.

There is a single powerful indicator left to worry about: the yield curve. Specifically, the yield spread between the 10-year and the 2-year treasury bonds, which remains deeply inverted to this day. Notebly, it’s not the inversion which has signalled a coming recession, but the UN-inversion of the curve, occurring as the Fed cuts interest rates. Whether in June or later, the Fed is bound to cut rates, and the curve will un-invert, putting investors in a tricky position relative to recent history. Expect a lot of “this time is different” headlines!

Part of the economy’s defying performance in 2023 (despite numerous recessionary indicators) has been continued fiscal and monetary support, following the pandemic spree. We can see both of these factors reversing heavily in the latest period by viewing the M2 money supply as a percentage of the full economy (M2 / GDP). Going forward, supportive measures will likely fade from any growth calculations.

Just the only data point to argue FOR a rate cut is the employment situation. We’ve been monitoring the BLS data releases for adjustments to previous figures and the grand image does not jibe with an economy running at full potential. Job growth has stalled in the past year. There are less people employed full time now than in February 2023 in the US. When full time job growth slows down (or turns negative year-on-year), the result is an economic downturn, especially since workers can scarcely rely on expensive credit to make ends meet.

While usually a lagging indicator, is employment top of mind for Jerome Powell and could it explain his dovishness since December?

Most troubling, the chart above shows the anemic job growth rate post-pandemic. While the media touts “strong employment reports”, those have mostly been driven by gaining back the jobs lost after Covid-19. The actual creation of “extra” new jobs, those that would accommodate an expanding workforce and immigration are simply… not there. As a consequence, the employees to population ratio has been trending lower over the past 2 decades and appears to have plateaued during the current cycle.

Maybe full time employees are being replaced with temporary help?

Apparently, that is not the case, as temporary help has seen hefty declines lately. The peak was recorded in March 2022, and we’re now on the cusp of 2 years of contraction. As can be seen in the chart below, a decline in temporary help is associated with economic downturns.

The labor market weakness is present at the sentiment level as well, with a larger share of consumers feeling more concerned about their future job prospects.

Our Trading Strategy

While there is no indication of a recession in the following 12 months, two dynamics are simultaneously at play:

• the stock market is optimistic and is pricing in a lot of positive outcomes;

• the Fed has one good reason to cut interest rates, despite loosening financial conditions;

As a consequence, it’s a matter of time until the yield curve un-inverts, and we’ll get to see the full reasoning behind rate cuts. For now, we can only guess that employment is the Fed’s number 1 concern (since people can’t consume if they don’t produce first, with rates at 5%).

In the equity market, we believe a correction is coming in the next 2-3 months and it could happen for a variety of reasons (or no reason at all other than profit taking). With earnings season over, the focus now turns to market technicals, economic data and the Fed. Now is not the time to be taking on excess portfolio risk and we’d rather take a defensive approach to our allocation.

We suspect there’s also a rotation on the horizon, with a transition from growth to value set to happen at one point. Going forward, our focus will be:

• Profit Taking

• Selling positions that are not working

• Only initiating new positions in “value” stocks

• Moving stops up

As the market remains bullish, such is also when a reversal risk is highest - something to keep in mind.

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