Weekly Preview / October 17
Notable Events on our Weekly Watchlist:
Monday: N/A
Earnings: BAC, SCHW
Tuesday: N/A
Earnings: NFLX, GS, IBKR, JNJ, UAL, ISRG, LMT
Wednesday: UK Inflation, Housing Starts
Earnings: TSLA, ABT, AA, ASML, IBM, KMI, LVS, PG
Thursday: Jobless Claims, Existing Home Sales
Earnings: ABB, AAL, T, BX, CSX, DOW, FCX, NUE, PM, DGX, SNAP, UNP,
Friday: N/A
Earnings: AXP, SLB, VZ
ETFs to watch: SPY, TLT
The Bullish Trend is at Risk
Last week’s trading has been marked by volatility yet again, as market participants digested the latest inflation figures released on Thursday. Investor’s nerves are starting to fray, as wild intra-day swings make emotions take over discipline and logical thinking.
The inflation report came in hotter than expected, cratering the equity market at first, and thus putting a huge numbers of options (puts) in the money. The secondary effect manifested throughout the session, as the S&P managed a 6% intra-day rally, to the close, largely due to a short covering effect. Friday saw the market unable to hold on to those gains, and declining by 2.28%, as the “fuel” provided by these put options started to fade. In this article I would like to outline as many objective points as I can, and reach a logical conclusion to a viable strategy for navigating the next phases of the market.
Bear Market or just a Correction?
Our readers know that this is not the first time that I am asking this question. While the mainstream media insists that a 20% decline in the benchmark index represents a “bear market”, such is an obtuse view given the extreme amounts of monetary intervention that Central Banks have provided during this market cycle. We need to resort to different means of determining if we are indeed in a bear market, from a technical perspective.
The 200-Week View
Using the 200-week moving average as a long-short signal provides one with a crude, but effective trend following model. The chart above starts in 1997 and displays weekly candles. You can easily spot breaks above and below the average, that generally align with confirmed bear and bull market cycles. According to this method, we are still maintaining the bullish trend intact, but only just!
Last week, the market touched, then rebounded off this average, at $349.50. Breaking this trend would be technical confirmation of a bear market.
Market Breadth
The chart above is a modified version of our Market Internals Overbought / Oversold instrument, that I have generated in order to highlight a few key points. First of all, the average score of a stock in the top 1000 by dollar volume is declining, as indicated by the orange trendline in the upper panel. In a bull market, we should see this average trending in an upper slope, or flat at the very least.
The fact that stocks on average are measured with a weaker score overall tells us that the market tenor has changed to the bearish side. Furthermore, in the lower panel, you can see the number of stocks oversold trend higher over the last 2 years. In a bull market, this is exactly how “Stocks Overbought” should look like, not “Stocks Oversold”. According to this instrument, we are already in a bear market.
The Signal Sigma Strategies
We have developed our investing strategies with the specific purpose of helping us deal with declining markets and volatility. Equities are currently not part of any of our automated portfolios. According to our models, even if we are not currently in a bear market, the risk is too high right now to take on any significant risk.
Other Fundamental Factors
Bear markets are usually accompanied by other factors that signal distress in the real economic environment. So far, we are only seeing distress in the financial economy (the stock market) and not the real economy. Note the absence of the following:
Surging unemployment
Bankruptcies, defaults
Falling yields due to risk aversion (stocks > bonds rotation)
Earnings recession
The Fed cutting rates in order to combat a downturn
The stock market is currently just starting to price in the possibility of these events occurring in the near future. The whole “Fed Pivot” narrative takes these pieces of fundamental bad news and treats them as good news, since they assume the Fed will “give in” and become accommodative (stocks rise on higher unemployment numbers). Once they actually start to occur, bad news will be treated as bad news, and we will probably see the market lower. Speaking of fundamental factors, BofA has created a useful table to track these:
The BofA List of Indicators before Market Bottom
BofA quants note that a series of technical and fundamental factors usually precede market bottoms. During the current downturn, we have only seen 2 of these trigger: extreme bearish sentiment and violent rallies. We can only assume that things will get worse before they get any better, as normally 8 of these factors should manifest. If you take a look at our Market Fundamentals Instrument, you will notice that Net Margins and EPS for S&P500 companies are still pegged at cycle highs. We will certainly see more turbulence, as Q3 earnings season gets underway this week.
The question that now remains is: how do we trade this?
SPY Analysis
According to our methodology, there are no immediate levels of support for the market that we can bet on. However, we are aware of different technical models that will flip from a Short to a Long allocation above SPY $360. There is still a good possibility of a decent reflexive rally in the weeks ahead, with upside to the 50-day moving average (392).
The market is deeply oversold, and highly extended from the 50 and the 200 day moving averages. Such extensions do not last forever and revert sooner or later. Furthermore, there are still a near-record amount of puts being sold to open by retail and professional investors alike. Should any rally catch some traction, these will provide even more fuel for a violent upswing.
Takeaway
Short term, the risk-reward equation favors the bulls. Using the 360 level on SPY as the pivot point for equity exposure makes sense, as various trend-following models are doing the same.
The plan in the medium term is to get the Sigma Portfolio to a fully market-neutral allocation. If a rally does occur, which takes the market to short-term overbought conditions, we will use that to flip our portfolio net short and speculate on further downside. For now, at just 5% net-positive exposure, we are content with our positioning.
Andrei Sota