/ September 25 / Weekly Preview
-
Monday:
N/A
Tuesday:
New Home Sales (0.7M exp.)
Wednesday:
Durable Goods Orders MoM (-1.4% exp)
Thursday:
Initial Jobless Claims (205K exp.)
Friday:
EU Inflation Rate (4.7% exp.)
Core PCE Price Index MoM (0.2% exp)
Personal Spending / Income
-
Monday:
Thor Industries THO
Tuesday:
Costco Wholesale COST
Progress Software PRGS
Wednesday:
Micron Technology MU
Paychex PAYX
Thursday:
Nike NKE
Accenture ACN
CarMax KMX
Friday:
Carnival CCL
The Fed’s Projections Sink Risk Assets
The market took a hit last week, as the Fed has projected “higher for longer” interest rates. They have effectively killed any hope of a rate cut early in 2024 and signaled a willingness to hike one more time at the November meeting.
While a lot of digital ink was spilled over the market outcome that came as a result of this meeting, the decline we are witnessing is absolutely normal in any given year. Bears came out of the woodwork and flooded various media outlets with doom and gloom. And while many concerns are indeed valid, the market is still in a broader uptrend, amid a bullish backdrop.
The correction aligns with seasonal patterns as well, with September notable for being a negative-return month. Many indicators are now signaling oversold conditions are present. From a sentiment perspective, we are almost (but not quite) at “Extreme Fear” levels. Technicals suggest the risk of a deeper pullback exists, if SPY cannot clear and hold $431 this week. In that case, the next level of support is at the 200-DMA, near $418, a further 2.79% decline from Friday’s close.
SPY Analysis
The MACD Signal turned sharply lower and is now markedly oversold;
As we noted in the introduction, the current correction aligns well with seasonal patterns, as well as nearing the average drawdown of the index for the last 2 years. The current drawdown is nearly 10%, versus the average of 12%.
October is usually the month when returns start trending positive, with the seasonally strong period peaking in late April.
However, there are some near term risks to this outlook that we should be aware of. An important level of support has been breached and has now turned into “resistance” - we are talking of course about the $431 level that did not manage to hold on Friday for SPY.
Adding to the weakness, volume has spiked to levels that are not encouraging for the bulls (high volume on lower prices is bearish). It almost looks like an anomaly on the chart - but this transaction dollar volume overcompensates for the lack of trading in the last couple of months.
Interest Rates and the Fed’s Model
All in all, Wednesday’s Federal Reserve rate decision was not a surprise. The language of their statement barely suffered any changes. It was Jerome Powell’s seeming willingness to hike rates again in November that spooked the markets.
However, mr. Powell needs to talk a hard talk. He can’t seem to flinch in the fight against inflation, especially given the strong readings the economy has been putting out lately. That is why he cannot appear to be “dovish”. On the contrary, he needs to appear “dangerous” and gain credibility by threatening markets with another hike.
Justin Lahart of the WSJ notes:
“The Fed projecting one last rate increase is also a way of preventing investors from immediately turning to the next question: When will the Fed cut? The risk is that as soon as investors start doing that, rate expectations will come down sharply, and with them, long-term interest rates, providing the economy with a boost the Fed doesn’t want it to receive just yet.”
The hope for rate cuts has the tendency to boost asset prices and increase consumer confidence and demand. The Fed doesn’t want that yet. They need options in case inflation picks up again. And the last thing the Fed needs is lower credibility.
However, it does not seem the market “bought” their message, judging by the latest Fed Funds rate. According to CME’s Fedwatch tool, odds of a rate hike at the November meeting are just 21.5%. At the beginning of last week (18/09), the odds were higher, at around 31%.
The issue with the Fed’s economic model remains: they have never projected a recession. In 2022, the Fed thought growth would be 3%. The figure was later revised down to 2.2%. As the Central Bank relies on many lagging data series, the tendency is to become overly optimistic initially, only to guide lower as reality sets in.
Rate hiking cycles have never had positive outcomes. Some sort of crisis event always occurred, be it in the stock or in the bond market (or both). It is very likely the Fed will be surprised in 2024 and be forced to act.
Their “no pivot” stance is a good reason to expect a pivot. However, the bond market has been punishing to investors recently, especially at the long end of the curve. From a purely contrarian point of view, bonds offer the best longer term setup. Consider that as the “lag effect” of the Fed’s policy impacts the real economy, higher interest rates will eventually weigh on consumption. U.S. government bonds are not a sustainable investment option with continuing losses mounting up to 20% per year (the CAGR slope of the trading channel).
This will absolutely force the Fed to tone down the hawkish rhetoric sometime in 2024, in our view. Even so, our systems are programmed to stop out long term bond positions at a close price below $87.79 on TLT.
Does the market offer up any value?
Consider that according to our latest fundamental based Market Outlook, there are good odds for expecting 1 year ahead returns of 12% for equities. This is well above what the equity risk premium theory suggests.
For clarity, using the equity risk premium formula, in order to justify the risk of holding stocks, an investor needs to be compensated 4% above the risk free rate. Currently, the rate for 1 year U.S. treasuries is 5.46%. An investor is considered to be adequately rewarded for carrying the extra risk when expecting to gain 9.46% in the following year.
Our more optimistic (no recession) estimate for 2024 calls for 222 in EPS, which would yield an almost 12% gain. The 0% growth (soft landing) scenario would not net a gain higher than the risk free rate however.
Respected economist Ed Yardeni has recently published a table of forecasts for the next year, and both his and the market’s consensus estimate is significantly higher than ours.
Yardeni Research projects $250 in EPS, versus consensus of $247. Our $222 estimate looks to be downright pessimistic.
Our Trading Strategy
Regarding bonds, Greg Feirman (@TopGunFP) sums it up:
“Personally, I think Powell is bluffing. He didn’t want to declare ‘Mission Accomplished,’ which would cause stocks and bonds to rally wildly, so he accompanied the pause with a lot of tough talk and hawkish projections. But I don’t think the Fed will follow through. I think they’re done raising rates and will wait and see what effect all the previous tightening has on the economy. This is also the correct course.
So what of it? Personally, I am looking to go ‘All In’ on long-term treasuries. TLT is testing its 52-week low of around $90 in the premarket – but I think it will hold. And I’ll use the selloff to add to my position.”
If he is right, this could in turn prove highly positive for equities as well. With sentiment readings reaching very low levels, now could be an excellent buying opportunity to add equity exposure for the next 6 months. This is certainly the plan for our portfolio as well, as risk and reward are well balanced.
Just remember that a good risk / reward ratio does not mean that risk is not present. Use and respect stop losses. Be aware of the downside for each of your positions. Be patient. The selloff could persist for another 2-3 weeks. For the moment, we are treating this as a buying opportunity.
Signal Sigma PRO members will be notified by Trade Alert of any 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), please reach out!
Have a great week and thank you for reading!