Equities Break Out

The equity market has been trading in a tight range for the past 45 days. Last week, we finally got a breakout! BUY signals have been triggered on Enterprise and Nostromo, courtesy of a positive MACD crossover. Moreover, SPY’s price has surpassed it’s upper channel trendline, and we can start working with new support and resistance levels.

This bullish development suggests we need to set our sights on $430 as the next target for SPY, while the rest of the market still needs to catch up. While the benchmark ETF looks overbought, most stocks in the broad market are not.

SPY Analysis

As the MACD suggests, the market is limited in the upside it can deliver, with 3.11% remaining until our $430 target is reached. If immediate support is breached at $417, the next support level sits 3.8% lower, at $402. The bulls have the technical upper hand here, with momentum on their side, while shorts are forced to cover.

Sentiment in the broad market is surprisingly neutral for such a breakout move. Instead of the exuberant “tops” we have seen previously in November 2022 or the January-February period this year, there are still plenty of bearish positions left. Not everybody is “all-in” on this latest move, which signals to us that there is “gas in the tank” to fuel the advance further.

Earnings Wrap-Up

As we’ve been accustomed to for the past 6 months, we are in the midsts of a tug-of-war between bullish Technicals and bearish Fundamentals. Bear in mind that it’s usually the technicals which move first, anticipating a recovery in earnings and growth prospects. If that is the case this time as well, then bulls believe we have seen the worst of the earnings and growth slowdown.

However, the yield curve and Leading Economic Indicators suggest the odds of a recession is virtually 100% in the next 12 months (they have never reached similar levels in the past without a recessionary onset).

From a yield curve inversion perspective, we need to go back to 1980 to find a similar difference between the 10-year and the 2-year. Without exception, in the last 40 years, when the yield curve has been this inverted, a recession has always followed. Stocks have also never bottomed before a recession. Could this time be different? What are the bulls thinking?

We need to explore the current earnings season for prevailing trends. As data has been updated according to the latest results, we track aggregated metrics for S&P500 companies with our Market Fundamentals instrument.

Based on the earnings reports from the majority of S&P 500 companies, we can gauge both the performance of the economy and the ability of companies to adjust to a high inflation, high interest rates environment. Many companies have beat estimates, according to FactSet:

“To date, 92% of the companies in the S&P 500 have reported earnings for the first quarter. Of these companies, 78% have reported actual EPS above the mean EPS estimate, which is above the 10-year average of 73%. It is also the highest percentage of S&P 500 companies reporting a positive EPS surprise since Q3 2021 (82%). In aggregate, earnings have exceeded estimates by 6.5%, which is above the 10-year average of 6.4%. It is also the highest surprise percentage reported by S&P 500 companies since Q4 2021 (8.1%).“ – FactSet

This sounds optimistic, until you account for the fact that estimates have been drastically lowered to begin with. If analysts were held to their initial (year-ago) prognosis, virtually 100% of companies would have missed. So where are we now?

Interestingly, we see an uptick in Gross Margins, when accounting for the latest reports. Net Margins remain subdued, however, as higher Gross Margins (related to product costs) cannot offset the squeeze happening in Operational Expenses (OPEX). Overall the drop in EPS is significant (21% from the June 2022 peak, to present values). The drop in EPS is also consistent with the October bear market through, that marks a 25% drawdown for SPY.

Our conclusion is that the bull thesis relies on growth picking up again in Q3 and Q4. Q1 earnings should mark the “bottom” in terms of EPS.

Takeaway

The current bullish price action in equities plays into our thesis laid out last quarter, when we initiated the closure of short positions and started to build long positions. As long as support holds, we believe there is still decent upside for the equity market near term. We will buy dips in unfavoured areas of the market in order to bring our performance more in line with the stocks / bonds benchmark that we are aiming to best.

Crowded areas include mega-cap Tech, and unfavoured sectors are related to small caps and financials (regional banks for example).

There is no need to move fast and “chase” the market currently - we’ll let bears cover their shorts in desperation. Instead, we’ll move to opportunistically raise the overall structure of the Sigma Portfolio from 40% equity exposure to 60% equity exposure. And as usual, we’ll keep you in the loop with our trades.