Weekly Preview / November 7
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The Fed, Midterms and Inflation
Last week the market was in a disposition to rally, having cleared important resistance at SPY $380 and heading higher after the Fed’s initial announcement of a 75bps rate hike. That risk-on mood quickly dissipated, as Jerome Powell started his press conference and clearly laid out a couple of important points:
There is no Fed Pivot on the horizon, and talking about accommodative policy is “premature”
The labor market is out of balance, remaining extremely tight
The important questions facing the Fed are how high will interest rates ultimately go and how much time they will remain restrictive
Finally, if things get really bad in the economy, there will be no problem to pivot, as the Fed has the tools to “support economic activity”
We take the view that speculators trying to find clues about the Fed’s monetary easing are not seeing the “forest from the trees”, as Jerome Powell spoke clearly - the labor market and inflation are the main drivers for interest rate decisions at the moment, not the level of the stock market. If anything, higher stock market prices will only give the Fed more ammo to raise rates in the future.
Also, with monetary policy as the main driver for asset price returns over the last decade, the Fed is well aware that in an economic downturn, they can always decide to restart QE, buy bonds and give a boost to the market. The only question is WHEN they will decide to do that.
Stocks promptly retreated during and after the press conference, breaking below the 50 Day Moving Average and technical support at SPY $380. The good news is that the market managed to hold minor support at the 20 Day Moving Average with the rally on Friday. Overall, the market declined by -2.73% for the week. Here is our technical take:
SPY Analysis
For the week, by far the most important economic event is Thursdays’s inflation report. Tuesday’s Midterm Elections are also an influential development, with the markets poised to cheer a gridlocked Washington (less likely to pass any controversial legislation that might upset current affairs). However, most traders and investors will use the next couple of days to position for Thursday.
We see an increased possibility of heightened volatility both to the upside and to the downside, similar to the market sitting on a powder keg. Trend following strategies will support any rally above 380-385, and provide “buy the dip” ammo to the bulls. Technical resistance sits at 390, but if the market manages to clear that, then the next important resistance level is way above at 405-407.
To the downside, a breakdown below the 20 Day Moving Average would trigger a negative MACD cross (SELL signal) that would most likely set the market up to retest major support at the 352 level, where the 200 Week Moving Average currently resides. To sum up, here are the levels indicated by multiple methodologies:
Upside Target - 407
Upside Pivot - 485
Downside Pivot - 372
Downside Target - 352
Technically speaking, the space between $372 and $485 is neutral territory, and automated models will not take any position.
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The market’s neutral predicament is clearly visible from our Overbought / Oversold Indicator that signals we are currently not near any extremes. Patience is required at the moment for a direction to be found. Our aggregate Z-Score analysis (pictured below) paints a more positive picture where the broad market is doing significantly better than SPY, creating a bullish divergence:
The bearish divergence that formed since May 2021 let us know in advance that the underlying strength of the market was weakening, and it was time to take profits and reduce risk. Similarly, while still in the early innings, we are noticing a bullish divergence starting to form since the June lows. This simply tells us that for the last 5 months, the average stock is performing better than SPY. Whether this pattern will hold or break down is a question for the following months, but for now it is just about the only technically bullish signal for the equity market.
Market Fundamentals
As most of the S&P500 companies have announced quarterly results, our Market Fundamentals Instrument is being updated at the end of each week. We find that gross margins are coming under pressure, as companies are feeling the effect of inflation and are having a hard time passing cost increases to consumers.
Another factor concerning retail-oriented businesses is an unprecedented build-up in inventories. Simply put, companies have a record amount of goods in store and cannot sell their merchandise fast enough (Shift Inventory). Expect heavy discounts in November and December.
Commodities, China
Commodities went gangbusters on Friday, with everything from Oil to Gold and agricultural produce and Copper getting a furious bid. The reasoning behind such a move was a rumor concerning Chinese Covid-rules relaxation and economic re-opening plans for Q1 2023. This would open up huge demand for physical commodities of every kind if proven accurate. Our thinking (especially in communist states) is that rumors more often than not prove to be true. China cannot stay closed forever, and they will need to re-open sooner rather than later.
Commodities have significant upside, and have been the only asset class to “work” this year.
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Takeaway
While the equity market is sitting in a tight spot with both significant upside and downside, Thursday’s inflation report will prove decisive. Everything else is just noise up until then. For now, we maintain a neutral to slightly bearish view. Inflation might be much more sticky than anticipated, giving the Fed less and less room to maneuver.
Bonds might be the best investment of 2023, but remain beaten down and un-investible for now.
Meanwhile the surge in commodities has blind-sighted ourselves (as well as lots of investors) specifically since Signal Sigma Strategies have built up significant positions in DBC, DBA, and GLD. These trades have proven incredibly timely and are now forcing us to play catch-up in the Sigma Portfolio. It was my mistake as portfolio manager for ignoring our own system’s allocation, but no process is perfect. As the investment thesis is confirmed, we will start buying the dip in commodities for the following weeks.
Andrei Sota
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