Rate drop fuels stock rally

Last week, yields on longer dated treasuries continued their descent, boosting (or at least stabilizing) bond prices and acting as a risk-on catalyst for stocks. As buyback programs kick in, professional managers start “window dressing” portfolios for year-end and large speculative net-short hedge fund positions gets unwound. All of these factors played into the seasonal strength disposition of the market and propelled SPY right past technical resistance.

However, with lower rates and higher stock prices comes the risk of resurgent inflation. Since both of these measures tie in with consumer confidence and spending, it’s no surprise that the Fed is keenly watching. Jerome Powell responded on Thursday to the recent loosening of financial conditions by reminding everyone that a rate hike is still a theoretical possibility:

“[The FOMC] is committed to achieving a stance of monetary policy that is sufficiently restrictive to bring inflation down to 2 percent over time; we are not confident that we have achieved such a stance. We know that ongoing progress toward our 2 percent goal is not assured: Inflation has given us a few head fakes. If it becomes appropriate to tighten policy further, we will not hesitate to do so.” – Jerome Powell

The Fed’s balancing act is what we suspect will continue to drive the “range trading” character of the market, going forward. When the market gets hot, the Fed threatens another hike. When pessimism prevails, Powell’s message becomes soothing. As a consequence, trend-following models and strategies (like the ones we have here, at Signal Sigma) are not best suited to handle this environment for the time being.

SPY’s short-term trading range remains $431 - $449. The more time the market spends above $431, the more likely a positive outcome becomes.

SPY Analysis

Despite the fact that lower yields and a surging stock market work against the Fed’s goals, hedge funds and other speculative investors are in “buy-the-dip” mode, bidding each pullback with relative conviction. It comes as no surprise that SPY successfully tested the 50-DMA on Thursday and bounced convincingly on Friday.

The data we follow from the Commitment of Traders (COT) provides a breakdown of open positions from 3 groups:

• Commercial Dealers

• Non-Commercials or Large Speculators

• Small Speculators

It’s the “Large Speculators” positions we are interested in, as this represents what money managers and hedge funds are doing collectively (green line). Since the peak of short exposure in June 2023 as SPY was trading around $430, these funds have increasingly closed their short positions, opting instead to become neutral.

We expect pullbacks to support levels to translate into buying opportunities for the time being. This should set up stocks nicely for a rally into year-end (though not necessarily in a straight line). Markets tend to be weak heading into the Thanksgiving holiday, and then stronger through the end of December again.

From a sentiment perspective, the broad market is trading in a Neutral disposition, and there is still “gas left in the tank” for a push higher. We do want to reduce equity risk exposure once the upper bands of sentiment are reached.

Large Caps have been the drivers of this rally, as the Market Internals / Z-Score divergence indicator demonstrates. Breadth needs to improve in order to sustain a more healthy advance.

This year has been a very bifurcated market, where only a handful of stocks (and 2 sectors) have performed well. If you missed these, your stock portfolio is likely flat (at best) for the year.

As a new year dawns on us, we need to understand weather stocks are indeed the best asset class to own. For now, the divergences we are seeing in the equity markets are not a concern, but they will become a problem in 2024.

Another risk-on catalyst that we are looking for and not currently getting is a respite in USD strength. All things being equal, a persistently higher US Dollar is not conductive to earnings growth, as many US companies derive earnings from abroad (roughly 40% of S&P 500 revenues are generated outside of the U.S). With the currency gaining 6% yearly on average, this translates into lower earnings growth.

Technically, we’d like to see UUP break below $29.63 in order to become more confident in reaching all-time-highs soon.

And, of course, the key driver for US Dollars is the yield they generate for investors who are holders of US debt. At 4.97%, 20-year yields are attractive enough to elicit demand (despite claims that foreigners are dumping US debt).

1 year inflation expectations are running at 2.77%, with the 1 year treasury bill yielding 5.39%, leaving investors with 2.6% of appreciation above inflation - a near record real yield. From a technical perspective, if TLT manages to break above the 50-DMA, the stage is set for an advance to $98, which should push the dollar lower and underpin a year-end rally in stocks.

Our Trading Strategy

We expect the market to consolidate in the $431 - $449 area. Technicals are mostly positive, and bears have been badly squeezed during this advance. This has now become a dip-buying environment, with a market that is not yet overbought. While the real buying opportunity occured in late October, nimble traders can still benefit from adding exposure on weakness.

As earnings season draws to a close, we’ll be watching the inflation report on Tuesday (3.3% headline / 4% core expected) and PPI on Wednesday (0.1% expected). Home Depot, Cisco Systems, Target, Walmart, Applied Materials and Alibaba all report results Tuesday through Thursday.

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