Fed signals “pause” not “pivot”

Last week, we got more of the same type of price action typical of the last month. The market was pushing against our upside risk limit on Monday ($417 on SPY), only to find itself succumb to selling pressure and test the lower level by Thursday evening ($403). The week ended somewhere in between, with Apple’s upbeat earnings report fueling a rebound on Friday, but unable to clearly break the balance.

The risk-off mood was fueled by the Fed and concerns that financial conditions have gotten too tight overall. The banking sector is still in immense difficulty, given the fact that money market yields are sucking up deposits from the system and forcing institutions to realize losses on their collateral. The Fed’s language suggested the Central Bank is on pause, but traders did not clearly see signs of a “pivot” on the horizon.

Nevertheless, markets remain bullishly biased in the medium-term, and we can consider the recent price action as a consolidation move. Support has held well both at the 50-Daily Moving Average and the S1 Level ($403). With the MACD Signal still in SELL territory, more pressure is expected in the near-term, with a possible upset on Wednesday’s inflation report. The earnings calendar is busy, but lacking in truly blockbuster announcements.

We remain focused on our key levels for risk-management purposes.

SPY Analysis

The Federal Reserve hiked interest rates by 0.25% for what appears to be the last time in this campaign.

“The FOMC statement used language broadly similar to how officials concluded their interest-rate increases in 2006, with no explicit promise of a pause by retaining a bias to tighten.” – WSJ

Indeed, while there was no explicit promise of a pause, there was no indication of a “pivot” either. Taking into account that Fed Fund Futures start pricing in a rate cut as early as July (34.5% odds), the Fed is very close to be in contradiction with market participants. The main problem for the Central Bank is the brewing banking crisis.

With interest rates hovering at high levels, depositors are incentivized to pull their capital from deposits and park them in money market funds returning 5% per year. In order to meet redemptions, banks need to liquidate assets (most of them treasuries) and realize losses on their balance sheet. Eventually, this process will put smaller banks into insolvency, as they become unable to meet their capital ratios.

The Fed will most likely need to deal with this situation before it gets out of control (there is a limit to how many regional banks J.P. Morgan can buy). If they choose to lower interest rates, inflation might flare up again. We suspect they will come up with an alternative scheme to shore up the smaller banks.

EPS falls below trend

Q1 Earnings Season has so far seen companies beat drastically lowered estimates, but failing to re-vitalize share prices. As shown in the graph above, combined EPS for S&P500 companies has fallen below trend on an equal-weighted basis. This is usually a threshold that encourages risk-taking, from a market timing perspective. Usually, by the time EPS falls below trend, the market has adequately discounted the full extent of the earnings slowdown.

This argues for the thesis that the real bear-market low has already occurred in October. Unless we get a truly disastrous economic outcome courtesy of the Fed’s rate hike campaign, we would read this as a bullish signal. Friday’s employment report of 269,000 jobs and a 0.5% wage increase, combined with a 3.4% Unemployment Rate does not argue for disaster currently (despite employment being a lagging indicator). We would be much more worried about sticky inflation that forces the Fed to hike further than it has already done.

Takeaway

Reduced equity exposure has served us well for the past weeks. We are watching for the key levels of the market at $403 to the downside and $417 to the upside. Breaking either of these would set the market up for a continuation, either to $427 in the best case or to $388, in the worst case.

All we can do currently is follow the price action and try to tease out some direction from market breadth and sector rotation. Neither of these is looking fantastic at this point, with narrow breadth and a sector allocation that looks defensive.

The bond market might offer a far better capital appreciation opportunity than the equity market this year. If we get a Fed pivot or any kind of crisis event, bonds should rally either way. The debt-ceiling debate is just that - a debate for the media and politicians - but is a non-issue for treasury holders. The U.S. will not default on its bonds (at the maximum, there could be some small delays in interest payments). We are looking at both markets to deploy our dry powder. As usual, we’ll keep you apprised with our trading in the Sigma Portfolio!