/ November 20 / Weekly Preview
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Monday:
N/A
Tuesday:
FOMC Minutes
Wednesday:
Durable Goods Orders MoM (-2.8% exp.)
Initial Jobless Claims (226K exp.)
Thursday:
N/A
Friday:
N/A
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Monday:
Agilent A
Zoom Video Communications ZM
Keysight Technologies KEYS
Tuesday:
Abercrombie & Fitch ANF
Nvidia NVDA
Autodesk ADSK
Analog Devices ADI
Dick's Sporting Goods DKS
HP HPQ
Kohl's KSS
Lowe's LOW
Nordstrom JWN
Wednesday:
Deere DE
Thursday:
Toronto-Dominion Bank TD
Friday:
N/A
Rate Hike Odds Vanish as Inflation Cools
Last week, we discussed how yields continued their descent, boosting all risk-on asset classes. Combined with the backdrop of favorable year-end seasonality, we did expect the equity market to trade up. But the rally that we got off of last Tuesday’s inflation report really blew the doors off our expectations (and our risk range) and has us thinking that bulls have gotten a bit ahead of themselves for now. The S&P 500 advanced more than 2% and further rate hike odds (at any point in 2024) are now below 3%.
With a holiday shortened week ahead of us, trading volume will be light, which may translate to increased volatility. NVDA will report earnings on Tuesday and will probably be the main catalyst in the short term. We will be focusing our research efforts on providing updated Fundamental Price Targets for the S&P 500 and the most important constituent companies. Our Quarterly Market Outlook is due to be published later this week.
Market rallies into year end come as no surprise. However, we are now reaching more extreme short-term overbought conditions, where a consolidation or slight pullback to support is expected. We would still treat any pullback as an opportunity to increase risk exposure for the moment. SPY has cleared the $449 technical level (which also coincides with our Scenario B fundamental Price Target) and the path is open towards all-time-highs. Support moves up to $440, as all systematic strategies will now attempt to buy-the-dip.
SPY Analysis
The MACD Signal is now highly extended to the upside, clearly indicating the higher probability of a consolidation or pullback;
The main reason that SPY gapped higher this week is closely tied to the selloff catalyst from late October: the Fed and the future path of monetary policy. During mid-October, Jerome Powell gave a speech emphasising the heightened probability of “one more” rate hike before the tightening campaign is over. Markets viewed the hawkish overtones as a net negative and succumbed to selling pressure.
From the October 27 lows, SPY has gained a full 10%, completing a roundabout move to positive sentiment. From “one more” rate hike on the table, we are now pricing in exactly zero rate increases going forward. The latest inflation report has traders thinking that the Fed is done and there is no chance of them tightening monetary policy further. Let’s take a look at Tuesday’s report by breaking down inflation subcomponents and their trends:
For the most heavily weighted components of inflation (Housing, Transportation and Food), the trend is lower month over month. This is entirely expected, as year-over-year comparisons ease and excess money supply (stimulus) fades from the calculations. While the abrupt drop in Energy is what pushed the headline reading lower, core inflation remains quite elevated and not that far from recent highs (4.02% in October vs 4.86% in June).
Furthermore, Sticky Price Inflation (goods and services included in the CPI that change price relatively infrequently, excluding Food & Energy) has shown a pleasing descent, but the rate of change of that descent is now slowing. In other words, despite the market’s assumptions, it’s not a given that the fight against inflation is won just yet.
There is ample evidence that the economy is slowing, as shown by last week’s negative Retail Sales report (-0.1%), falling US Industrial Production (-0.6%) and PPI (-0.5%). The current spread between the Producer Price Index (PPI) and Consumer Price Index (CPI) suggests that manufacturers are having a hard time passing on production costs to consumers, thus eroding gross margins. This supports the notion that earnings will also have a hard time growing until the disparity is resolved.
For now, the market has taken this batch of “bad” data as “good” in the sense that it will lead to lower interest rates down the line. However, there will come a point when “bad” data will be taken at face value - “bad”. As long as the economy avoids a recession and employment remains strong, the Fed has no reason to cut rates. In the Fed’s chairman’s own words:
“[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
Gross Margins for S&P 500 Companies retreat and stabilize near cycle median as of Q3 reporting;
With the stock market rising and yields dropping over the past week, financial conditions have essentially eased. The issue with loosening financial conditions is that it risks a resurgence in inflation, contrary to what the Fed is trying to achieve. The bullish case for the markets relies on a couple of assumptions:
The economy avoids a recession
Employment remains strong, wages support consumption
Margins do not erode further, supporting higher valuations
Revenue Growth resumes, reversing the current trend
The Fed does indeed pause rate hikes
Against this fundamental backdrop, we expect to find ourselves firmly entrenched in a “range trading” regime, where reversals happen often. Our trend-following models will be prone to buy high and sell low, so we need to correct part of their behavior using this understanding. The Market Sentiment instrument will probably be best suited to attain this goal. And right now, the Sentiment reading is 68 / 100, closing in on “Extreme Greed” territory, when it will be time to scale back some of our more overbought positions.
With monetary conditions loosening, bonds have bounced back courtesy of lower yields. TLT has set a base near the M-Trend level of $84.2 and appears to be headed toward S2 resistance at $98. We would not be surprised to see the benchmark treasury ETF trading in this range for a while, before eventually headed higher. As mentioned earlier, easier financial conditions work against the Fed’s goals for the time being, so we expect plenty of “jawboning” in an attempt to subdue any inflationary resurgence. This would limit upside for bonds for the time being, absent a recession.
There is also a fundamental backdrop to this technical support: an understanding that the market implied US Terminal Rate has now converged with the Fed Funds Effective Rate, practically setting a floor to bond prices.
Lower relative yields translate into less demand for the currency backing that respective bond - in this case, the US Dollar. UUP (USD tracking ETF) is now oversold in the medium term and barely holding near S1 support at $29.3; continued pressure on the USD has the potential to send it much lower, near $28.4, where both the trend-line and the S2 level reside. This would be a bullish technical catalyst for all of the other asset classes.
Our Trading Strategy
The equity market is getting hot, and the time to take some profits is not far away. The tug-of-war between the Fed, inflation and market participants is set to continue, and with it, a trading environment where dramatic reversals are the norm. Whenever asset markets get bubbly, we expect the Fed to intervene and cool things off. The obvious place to rotate from stocks is the bond market - currently offering much more safety and capital appreciation upside.
As mentioned at the start of the article, we will be releasing an updated Quarterly Market Outlook by the end of this week. The report will set new fundamental price targets for the S&P 500 and we will also lay out our strategic vision for 2024.
For the time being, investors have been allowed to chase stock prices back up. The economy has not performed as poorly as feared in 2023. However, things need to meaningfully improve in 2024 in order to “keep the party going”. Such may or may not be the case going forward, but the rules for investment remain the same:
Trade the market we have, not the one we wish for
Manage risks through the use of stop levels and profit targets
Control emotions, approach every trade and position in a disciplined way
For now, equity dips can be bought, aiming for a bit more of a year-end rally. Risks can also be rebalanced in portfolios by selling losing positions and harvesting tax benefits. If a position didn’t perform with the rally so far, it’s unlikely to do much better in the near future.
Signal Sigma PRO members will be notified by Trade Alert of any live portfolio changes (if subscribed). If you’re not on this plan yet, you can get a free trial when you join our Society Forum. If you need any help with your trading strategy (or would like to implement one on your account), feel free to reach out!