Notable Events on our Weekly Watchlist:

Monday: N/A

Earnings: ORCL

Tuesday: Inflation Rate, CPI

Earnings: N/A

Wednesday: PPI

Earnings: N/A

Thursday: Jobless Claims, Retail Sales

Earnings: ADBE

Friday: Michigan Consumer Sentiment (preliminary)

Earnings: N/A

ETFs to watch: SPY, TLT

Holding support, but will recent strength continue?

Last week, the market held support at the level isolated by our system (389.17). In our previous article, we laid out 3 possible paths for the short-term price development, giving more weight to a “bounce”. To wit:

It seems we are now in scenario B or C, where the rally from short-term oversold conditions will be put to the test. This week, we will get the latest inflation figures on Tuesday, which will move the markets significantly. We will either get a convincing breakout above the lower technical trendline, or the rally will fail at this important juncture.

SPY Analysis

We have updated the chart with the two remaining short term paths. The level to watch now becomes 409.35, as a clear break above this would signal a return to the “regular” trading channel for SPY, and would trigger trend following algorithms to bid the market up. Another short term signal that could turn bullish is the MACD (circled below), which will turn positive on a break above 409. If this signal were to trigger within the “regular” trading channel for SPY, it would determine our own strategies to also become buyers.

In order to assess the odds for either scenario, we need to understand how the market is positioned before the inflation report. On the right-hand side of our chart, you can see the Overbought / Oversold indicator sitting at exactly 50/100. This is a medium term indicator, and is used to gauge the price action of the last 2 months. It makes sense that it is giving us a neutral reading. However, as we frequently point out, SPY is not the market.

We shall also need to consider the Market Internals reading, which averages the same indicator for the top 1000 stocks by transaction dollar volume.

With a score of 57/100 and neither extremes reached (lower panel), the overall positioning of market participants is as neutral as it can get. We would rate the possibility of a breakout (or breakdown) as essentially a coin flip from a pure technical perspective.

On longer term time frame, we are concerned about the precipitous decline in trading volume, as is evidenced below.

Market Internals / Dollar Transaction Volume

Transaction volumes have been steadily declining since the start of the year. The Fed is main culprit behind the removal of liquidity, as the tightening of financial conditions takes its toll on the financial markets. As QT goes to the max starting this month, we expect to see an even larger impact on trading volumes. By itself this would not be a huge problem, but we are aware of 2 dynamics:

Lower liquidity brings about higher volatility (as it’s perfectly clear from the chart);

Higher volatility, if sustained, is a headwind for asset prices (again, the correlation is pretty clear).

In order to get fundamentally bullish at this point, we would need for these correlations to break (eg. subdued volatility on low volume).

There is a bullish development that I would like to point out when it comes to the internals of the market. We have seen the number of stocks trading above the 200-Day Moving Average steadily drop since January 2021. This was an early warning that something was “off” in the equity markets, despite the S&P making new highs. We are now witnessing a reversal of this trend, in what could be an early, but similarly significant point.

Takeaway:

With the short term price dynamics at the mercy of the inflation report, we will be buyers of a breakout. At the same time, failure to break above 409, will signal trouble with the current rally and an outsized possibility that we would see lower lows this year.

The question of wether we are in a bear market or just a correction is still on the table, and we’ve yet to find an answer. However, there are structural macro headwinds that point to sticky inflation and a longer timeframe for the Fed to keep financial conditions tight. We are 28% long entering this week (see the Sigma Portfolio), but our positioning reflects “speculation” rather than “investment”.

In other words, we are giving the market the benefit of doubt for now. The fragility indicated by transaction volumes is concerning. Should conditions worsen, we will be ready to deploy hedges and not get caught off-guard by a move to the downside.

Andrei Sota