We’ve mentioned in past articles that to understand and determine the direction of financial markets, they must be analyzed in different timeframes. Our Investment Process Model uses short-term, midterm and long term periods to determine bullish, neutral or bearish trends. The benefit is to invest capital in the same direction of financial markets trends.
After the closing bell in New York on January 26th our model triggered a short-term bearish signal for the S&P 500 Index. Measured in percent, we’ve seen similar pullbacks and corrections during 2020 and 2021. Those corrections, with the exception of the Covid-19 collapse in February / March 2020, did not trigger bearish signals because they did not cause the technical damage that the current drop did. Therefore, the newly triggered short-term bearish signal.
Although it is impossible to know for how long a signal will remain bullish, neutral or bearish, the short-term signal is the warning shot. It may last a day, a few days, a few weeks or longer. The depth and strength of the short-term bearish signal has an effect on the speed at which the mid-term signal may or may not change. This is important because the weight of the mid-term signal is larger than the weight of the short-term and long-term signals whilst determining the direction of financial markets. The combination of the three trends allows us to determine the Main Trend of the market in question. We perform and publish this quantitative analysis for several markets and indices. Check our Market Trends Table here.
The mid-term trend of the stock market went from a weak bullish uptrend at the beginning of the year to at least being a mix market now, with a bearish bias. Nonetheless, the stock market could snap and flip back at any moment. The S&P 500 has been oversold for at least four days, which could lead to a consolidation or a bounce, but up to now it would be a bear market bounce. After the bounce takes place, we would have to evaluate what is behind the bounce to conclude whether or not such bounce is credible and sustainable.
This is a significant change from what we’ve been seeing and saying up to the last quarter of the year in which pullbacks in the market were supposed to be bought. The short-term bear signal shown by our Investment Process Model on Wednesday 26th prevents us from buying pullbacks until the signal goes back to bullish. Perhaps the best way to present the case is using the tradable S&P 500 Index ETF, SPY:
- If you had to place a trade to be held for the next day to 4 or 5 days, what would that trade be? Considering that volatility remains high and SPY is oversold, the probability is that a short-term bounce is likely to occur, especially now that the Federal Reserve (FED) meeting is behind us. Then a speculative buy would be appropriate for a nimble trader.
- Would you buy or sell SPY if your timeframe for the investment is 3 months? The answer is probably sell because significant rallies usually occur with volatility readings above 40 and this time around, VIX reached only 38 to close at 27.66 on Friday 28th. Therefore, we may have not seen the worst of it yet.
- Would you buy or sell SPY if your timeframe is at least 1 year? Since we currently believe that we are in a secular (long term) bull market, buying the ETF now could be appropriate.
The FED meeting is now behind us and Jerome Powell did what he was expected to do, leaving rates unchanged. However, investors seem to fear he will make the same mistake he made in 2018. The economy peaked in the third quarter (Q3) of the year and at the time that GDP growth started to decelerate, the FED kept insisting in raising rates 3 or 4 times during 2019. In fact, they hiked rates by 25 basis points in their 12/19/2018 meeting. Regardless, the bond market pushed yields LOWER in anticipation of lower GDP growth and inflation ahead, which was the complete opposite of what the FED was announcing and doing. To make the long story short, the FED ended up CUTTING interest rates THREE TIMES in 2019. The bond market was right and the FED was not. Therefore, it is important to continue monitoring the bond market for clues as where yields will go from here. Sooner or later the FED will do what the bond market does.
Besides the FED, yield spreads are another variable worth looking because stocks perform much better when spreads are narrow. In other words when credit markets are under no stress. Widening spreads are highly correlated with stress in the credit markets and stocks tend to perform very poorly in such environment. AAA, BBB and high yield spreads remain at low levels, but they have been widening since September / October. The yield curve is flattening (a sign of stress in the economy) and stress levels are gradually increasing in the bond market. The problem with this scenario is that spreads tend to move gradually, until the big widening move happens all at once and financial markets collapse.
Interestingly enough, copper is tittering within a barely bullish consolidation process after a 70% increase since June 2020. This at the time that China’s (FXI) Main Trend is bearish, which means that both, short-term and mid-term trends are bearish. Copper and China are usually seen as indicators or thermometer of the world economy because copper is a pure industrial play and China is the largest converter of raw material. If these two are not doing well, which is not yet the case due to copper remaining in a shallow bullish consolidation, then the world economy is not doing well. It is important to follow copper and the yield curve for further clues on economic growth.
Hint: the Main Trend signal of the Russell 2000 Small Cap Index in the U.S. is bearish. This is important because small cap is a 100% investment in the U.S. economy. Small capitalization companies have very little, if any exposure to international markets. The index is down -20% since November 8th which should tell us something about the U.S. economy.
We all understand why the FED is on a crusade to hike interest rates. As mentioned above, the problem with hiking now is that they may be repeating the mistake made in Q3 2018, hiking rates at the time that the economy is cooling down (more on this below). Such a mistake may take the U.S. economy into an unnecessary recession. The FED had about 16 months to hike rates in order to control inflation, but they thought it was transitory. Now investors expect the FED to increase the overnight rate during their meeting in March and three or four times throughout the rest of the year, therefore the increase in volatility in financial markets.
Since the peak in November 16th the retail sector (XRT) dropped -27.5%, consumer discretionary (XLY) -11%, technology (XLK) -11% after being down over -14% the week prior, transportation ($TRAN) dropped -12%, materials (XLB) -10%, health care (XLV) -8.5%, real estate (XLRE) -10.5%, utilities (XLU) -6%, consumer staples (XLP) -4% at the time that energy (XLE) is up +24% since mid-December, the US Dollar is +4% since late October and gold (GLD) tittering over a slight uptrend, undecided but on uptrend nonetheless. All this is important because during the last part of phase 3 in the economic cycle and just before entering phase 4, where GDP and inflation decelerate at the same time and financial markets collapse, the last sector to make the final move up is energy. Additionally, the U.S dollar regains its strength and gold moves up in expectation of lower yields. History shows that when this happens, the only safe investments in town are the US dollar, gold and long U.S. Treasuries if lower yields are probable. We find quite interesting that just now, coincidently with the FED enthusiasm to hike rates, there is strength in energy, U.S. dollar and gold (although undecided). It’s like Q3 2018 all over again.
The FED can still avoid collision if they manage to understand where we are in the economic cycle and follow the bond market. If this is the case it can be a soft landing of the economy and financial markets, otherwise protecting capital seems like a good idea. After all, if the consumer (retail down -27.5%) is not responsible for overheating the economy (inflation), the FED should probably consider the supply chain issue as a probable cause of inflation. If this is the case, we seriously doubt that increasing rates will solve or alleviate the problem. On the contrary, it could make it worst because capital will be more expensive for all consumers and businesses. In our opinion it is very likely that the supply chain issue will be resolved throughout time as the world economy gets back to normal.
Therefore, even in the worst case scenario in which inflation and GDP decelerate at the same time, in our estimate the current high level from where both would slow down, should prevent a recession and a bear market if the FED is capable to understand the bond market. No doubt in our minds that this scenario will develop further during Q1 and Q2 2022 and volatility should remain high.
A word on volatility (VIX): between $30 and $40 only very short term speculative oversold bounces are tradable. VIX between $20 and $30 is like a chopping board, only apt for nimble traders. Everyone else chops capital. VIX below $20, we go back to normal and the bull market resumes (most likely). Remember that investing is about probabilities. It is all about probable scenarios….
(*) The Greenwich Creek Capital “Index Trend Table” is not meant to be used in isolation, it is part of a more complex set of variables and it is not designed to provide trade entry and exit points.
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