Stocks stumble in early September

Last week, the market was marred by headlines highlighting various risks. Growth concerns originating in China and Europe; valuation anxiety in the tech sector; the rise in oil prices and interest rates - all of these subjects meant buyers went on strike and most asset classes pulled back from recent highs. The equity market sold off decently after topping near our designated short-term resistance level ($449 - R2). SPY did not manage to hold its 50-DMA, but it didn’t convincingly break below this level either.

Given that market participants are quite “Fearful” and that September is a seasonally weak month, we can expect more sloppy, sideways action, for now. Eventually, as long as an economic calamity does not occur, equity indices should grind higher once the seasonally strong period starts into year-end. After all, portfolio managers need to “dress-up” portfolios and many traders are chasing higher returns due to them underperforming the market in 2023.

SPY Analysis

So far, the S&P 500 is following seasonal patterns pretty well. The chart below, courtesy of isabelnet.com, shows the historical average return in pre-election years, highlighting the consolidation pattern we are currently experiencing.

Interest rates, Oil and the Economy

In an unusual twist last week, both oil and the U.S. Dollar surged. This short term high correlation is bound to break, as both assets cannot mutually continue on the same path for long. The cause for the spike in oil prices came on the back of Russia and OPEC agreeing to cut production.

USO, the ETF tracking oil prices, is nearing technical resistance at the R1 level and is now heavily overbought (96/100). This is a level where corrections or consolidations have typically occurred, as the technical range is quite wide. Despite the headlines and the aggressive short term move, the overall picture in oil is one of sideways trading, within a very large supply and demand band.

The recent surge in prices (mid 2022) came as a direct result of a flood of COVID-related stimulus. This kind of fiscal policy has artificially created a consumption boom and has significantly pulled forward demand. When high demand met limited supply, the result was inflation, which is translated into higher commodity prices.

However, since the middle of 2022, oil has started to decline along with inflation rates, as growth has normalized and consumption returned to normal levels. We see the current spat of higher prices as somewhat temporary. Eventually, deflationary trends will return, especially in a economic recession scenario. What about the U.S. Dollar?

The Dollar is highly overbought as well (99/100) and touching technical resistance at the M-Trend level ($29.4). The breakout in the Dollar normally has every other asset class on the back foot, as it usually follows higher interest rates, in the following cycle:

-> Higher yields create demand for the currency and result in lower bond prices; gold also suffers, as it’s a non-yielding asset class;

-> Higher interest rates pressure valuations, as discounting companies cashflows gets more expensive - this results in lower stock prices;

-> Lower stock prices decrease economic activity at the margin as the wealth effect translates into lower discretionary spending;

-> Additionally, consumers that spend more “at the pump” also have their discretionary budgets squeezed;

According to this logic, spikes in oil prices eventually lead to deflation. History supports this thesis, and it is the reason we argue against simultaneous high oil and an expensive US Dollar. This correlation will break sooner rather than later.

In this scenario, persistently high oil prices will eventually result in an economic slowdown, allowing yields to lower and starting the cycle all over again.

“High oil prices add to the costs of doing business. And these costs are area also ultimately passed on to customers and businesses. Whether it is higher cab fares, more expensive airline tickets, the cost of apples shipped from California, or new furniture shipped from China, high oil prices can result in higher prices for seemingly unrelated products and services.”

“It should not be surprising that sharp spikes in oil prices have been coincident with downturns in economic activity, a drop in inflation, and a subsequent decline in interest rates.– Investopedia

Currently, TLT, the ETF tracking long term government bonds, is on an unsustainable -21% CAGR trend (if TLT continues falling at this rate, it causes holders a 21% loss each year). Crucially, as bond prices decline, yields rise and further dampen economic activity.

Furthermore, oil prices are not included in the Core Inflation metric that the Fed is watching for setting interest rates. Inflation figures for August will be released on Wednesday, and will be the focal point of analysts this week.

We believe that the “high oil = high inflation” narrative that has spooked the markets recently does not hold up in the medium term.

Growth returns to normal, merchandise starts to move

Our Market Fundamentals instrument aggregates weekly data from S&P 500 companies and presents a series of graphs. As data from Q2 Earnings Season gets accounted for, it’s useful to gain some insights from these stats.

The chart below show Revenue Growth normalizing from > 20% after the pandemic, to ~5% currently, near the historic median.

Despite the slowdown in Revenue Growth, we find inventories finally start to shrink, from overly bloated levels (higher inventory turnover is better for economic activity).

Analysts are penciling in a return to higher growth rates in 2024, supported by an accommodative Federal Reserve and a resilient economy. There are plenty of issues to overcome, however: restarting student loan payments, slowing job growth, elevated interest rates. All of these factors (including higher oil prices) will dampen economic activity going forward.

Our Trading Strategy

For now, technicals and seasonality suggest markets will remain resilient and not break down. We are watching for support levels to hold on the main indices, especially on Wednesday, post CPI data. Leading up to Wednesday, we expect trading volume to be on the light side, accompanied by subdued volatility.

For now, our Live Portfolio is at target allocation, carrying plenty of risk in various asset classes. The U.S. Dollar’s rally should finally cool, buying everything else. 2024 is another subject entirely, as the risk of a recession rises markedly. But that is a concern for a different time. The aim right now is to manage exposure accordingly and use rallies to take profits into year-end.

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