Summer Weakness supports Year-End Strength

Last week, the market meandered in a volatile and sideways fashion, with SPY finishing lower by -0.44%, after having declined more than 2% peak-to-through. There was a distinct negative bias present, as Q3 wrapped up, and up to 20% of funds made their year-end distributions. Moreso, end-of-quarter rebalancing and window dressing by portfolio managers contributed to the volatility across all asset markets.

However, equities did manage to bounce slightly overall, and have exited oficial “oversold” conditions. This is encouraging from a technical perspective, and a continued rally into year end is supported by historical statistics. In order to maintain a more bullish posture, SPY needs to hold previously oversold levels ($426), and eventually break above $431 Resistance. If these cannot be achieved, then a full retracement to the 200-DMA, at $419 is to be expected.

First, let’s cover the chart levels:

SPY Analysis

With the seasonally weak May to September season now over, the S&P 500 registered a mediocre 2.88% advance during this period. The equally weighted version, however (RSP ETF) registered a decline of -2.29%, as the impact of heavyweights AAPL, MSFT, GOOG, NVDA, TSLA is greatly muted in that variant of the index.

Given that most stock portfolios own many other names, we would expect their performance to be 0% at best over the same period. From our own stock picking strategies, only Millennium Momentum has managed to outperform. The good news is that, historically, October-December rallies tend to follow weak summer returns.

As shown in the table above, courtesy of Carson Research and Factset, negative returns in both August and September (similar to what we have experienced now), almost unanimously lead to positive October and Q4 outcomes. In the past 70 years, only 1957 produced a negative result.

Since most “bad news” is currently priced into both stocks and bonds, the risk is relatively low for a further significant decline. Here’s what’s currently accounted for:

• The Fed potentially hiking rates further;

• Weaker economic growth;

• Inflationary pressures re-surfacing;

• A lackluster Q3 reporting period;

Our sentiment measure did not bottom without good reason, after all. The average stock is now experiencing a drawdown exceeding 30%, an unusually large decline.

What could spark a rally?

There are several technical and fundamental reasons to expect a rally into year end, leaving history aside. First of all, the corporate blackout period for stock buybacks is ending.

Goldman Sachs notes there could be 5B in repurchases in Q4 alone. These buybacks have provided a solid tailwind, particularly in large cap names, which tend to impact index prices (and overall risk sentiment) more.

With SPY now experiencing a distinctly average 6.5% pullback, the market is no longer overbought and extended. All factors are registering a negative Medium Term Trend, and most are trading below ALL key moving averages (Growth and the Nasdaq are sole exceptions).

This kind of overly negative short-term alignment, in the context of bullishly trending markets is usually where we identify buying opportunities. From a contrarian viewpoint, such a technical backdrop presents an ideal scenario, as it provides the necessary "buying power" for the markets in the short term.

Q3 earnings season is another potentially positive catalyst. As is the case during every such season, analysts have lowered expectations enough so more than 70% of companies can beat estimates. As can be seen on the Dashboard / Stock Ratings, most companies we’ve done fundamental work on have a healthy appreciation potential to their respective Price Targets.

One of the main catalysts for the latest decline have been treasury yields. Higher yields take their toll on stock prices by virtue of rewarding investors with a higher risk-free rate. In turn, projected cash flows that are the bedrock for any valuation, suffer a larger discount, bringing today’s “fair value estimate” lower.

As it turns out, many hedge funds and large speculators are positioned net short against bonds, at the highest level ever recorded! In case treasury prices rise, there is an enormous short squeeze waiting to happen. If and when this massive short covering occurs, equities valuation should benefit.

Our Trading Strategy

We have recently begun to slowly increase risk allocations towards our ultimate target. We will continue to do so this week as well. The plan is to hold all positions into the first part of 2024, as the risk-reward setup we have currently is favorable.

We suspect that as the next year shapes up, bonds are more likely to outperform stocks, by a large margin. But that is an entirely different story, and we’ll need to wait for euphoria to return to the markets in order to start offloading stocks. Now is the time to remain contrarian and stomach the volatility.

This week, investors will be eyeing Purchasing Manager Index data on Monday (Manufacturing) and Wednesday (Services), and listen to a host of Fed speakers, including chair Powell, also on Monday. The Employment Situation Report will be released on Friday, with 150K jobs expected to be added while the Unemployment Rate is expected to come in at 3.8%. Softer figures should boost both stocks and bonds.

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