I always write my articles in a way in which the flow of the information leads to the final conclusion of it. This time around, capital in the stock market is rotating so much and confusing so many that I’ll start by the conclusion:
The stock market has been in an uptrend since March 2020. It is now in a corrective period which we don’t know how long it will last or how many more points it might lose, but as of now, this is not the beginning of a bear market. A 5% decline is not even a correction. It is more of a pullback, which could evolve into a correction. If this were to happen, the stock market might enter into a multi-week decline or consolidation. In our opinion, last Thursday’s gap up and breakout in the S&P500 occurred with very low participation, which may suggest further weakness ahead.
Now, the facts:
When the new Covid Delta Variant cases increased during the summer months, the yield curve dropped, GDP slowed down and gold seemed to regain upward traction while the Federal Reserve (FED) kept insisting that inflation was transitory. As the Delta Variant case count decreased in August / September, the yield curve steepened again indicating an acceleration of GDP growth, gold lost its momentum and the FED now seems to have dropped the idea of transitory inflation.
Furthermore, most commodity prices remained strong during the recent market pullback. Financials, banks, energy and airlines improved indicating a rotation of capital out of growth and into value is underway (again). As time goes by and economies catch up with normality, these swings of capital originated by investors chasing performance will get smoother, like they used to be.
Money moved out of high-beta ETFs, rate sensitive groups such as REITs, Utilities and Telecom. Former leaders in Healthcare and Medical Devices also lost ground. These seem to be all part of the rotation of capital mentioned above. Although these groups are performing worse relative to the S&P500 index, it is not a sign of a bear market but a sign of confidence in more cyclical sectors.
In September and early October, Mid-Cap and Small Cap stocks had better performance relative to large cap. These two held up better with a smaller decline than the S&P 500 SPDR and Nasdaq. Definitely, not a sign of a bear market because Mid-Cap and Small Cap stocks are considered riskier than large cap.
The spread between US Treasury Bonds and Corporate bonds from AAA to BBB, including high yield and junk bonds, remained narrow during the September pullback. This is an indication that there are no signs of stress in credit markets and a sign of confidence in financial markets.
The Federal Reserve’s Balance Sheet Expanded las week and contracted the previous week. We believe it was the biggest contraction since July 2020. It is too early to say if this is a sign of tapering or just a coincidence.
Main Points:
- Although subject to change at any time, our model remains Bullish. This is the same model that allowed us to catch every bear market and correction since the Internet Bubble, including the mortgage crisis.
- Participation has been narrowing. An expansion in participation should be bullish (seasonality).
- Treasury Yields broke out and we expect the trend to continue.
- Gold becomes oversold within a downtrend. Its choppy action gave short term traders with opportunities to profit from oversold bounces but always on downtrend.
- U.S. Dollar (USD) breaks out of range. Perhaps this is the reason for the downtrend in Gold. The USD formed a bottom and consolidation in May / June and it is now breaking out into a new uptrend. Remains to be seen if the new uptrend is sustainable. Consider that a stronger USD may put a lid on commodity prices and inflation. This scenario would be good for the FED and the stock market.
- Oil Extends on Channel Breakout and in uptrend after downtrend consolidation during Jul / Sept.
- SPY Pulls Back within Bigger Uptrend.
- QQQ Barely Bounces, gaps up and falls back.
- Financials and Banks are leading with breakouts (this is typical of Phase 2 of economic growth where GDP and inflation accelerate, usually with a weaker USD).
- Energy ETFs extend on wedge breakouts (also a Phase 2 economic growth event) including oil (XLE, XOP) and natural gas (UNG).
- Metals and Commodity ETFs Lead with Breakouts.
- Prior Leaders QQQ, XLK and XLC gap up and stall (we believe this is temporary).
- Tech Related ETFs Become Oversold, but Lead lower in September.
- Biotech ETF IBB is under pressure perhaps influenced by a pullback in Moderna (MRNA).
- Strategic Metals ETF forms a small falling wedge within uptrend. Zinc & aluminum are doing fine while copper (not a leader) is weighing on DBB (base metals) and SLX (steel) is a laggard.
- XLI (industrials), XLB (basic materials) and SLX are under pressure with no breakouts.
Our model remains in correction mode and bullish overall.
The fact that yields are moving up is an indication of economic acceleration and the type of leadership we are seeing from financials and commodities leads us to believe that we are back to GDP and inflation accelerating mode. If this assumption is correct, then it is only a matter of time until technology and growth catch up with the rest of the market.
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