The Market Mosaic 1.22.23
The bear market lows are in...unless this happens next.
Welcome back to The Market Mosaic, where I gauge the stock market’s next move by looking at macro, technicals, and market internals. I’ll also highlight trade ideas using this analysis.
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And be sure to check out Mosaic Chart Alerts. It’s a midweek update covering my best chart setups among long and short ideas in the stock market, along with specific levels that would trigger a trade.
Now for this week’s issue…
The stock market is off to a fast start in 2023.
With the S&P 500 up nearly 4% in just three weeks, the strength has caught many by surprise. That’s because a sharp drop in December made it look like a return to the lows could be looming.
But even as the S&P struggled to find its footing, I posted this at the start of January about how improving breadth was lurking underneath the stock market’s surface:
At the end of December, I also discussed here how collapsing volatility levels could draw institutional flows back to equities. And I believe that’s the scenario currently playing out.
A drop in the Volatility Index (VIX) has been accompanied by “breadth thrusts”, which is a surge in advancing stocks relative to declining ones. Those thrusts are important because it takes institutional activity to generate that kind of strength. There are many ways to measure thrusts, but here’s one along with historical return stats from Ryan Detrick.
The table shows historical return profiles when you see a high ratio of advancing stocks relative to declining ones over a 10-day period. That’s the kind of buying power needed to put the bear market behind us.
So does that mean the lows are in, and the worst is in the rearview? The answer comes down to one variable.
The “R” Word
It may come as a surprise that earnings for the S&P 500 likely increased 5% in 2022 once 4Q earnings are tallied. That means the first phase of the bear market was driven entirely by valuation compression, or a falling price-to-earnings ratio as you can see in the chart below.
You can thank an aggressive Federal Reserve and rising U.S. Treasury yields for that. I discussed here how rising rates negatively impacts the stock market’s valuation multiple.
And rising interest rates will also drive the next phase of the bear market…if it occurs. This time, it’s all about how rising interest rates are taking a toll on economic activity and corporate profits.
That means the bear market’s future hangs on that “R” word: Recession.
If a drop in economic activity drags corporate earnings lower, then I expect that will be the next big catalyst for falling stock prices. On the other hand, if a recession can be avoided then the bear market lows have likely been seen. The chart below from 3Fourteen Research shows how past bear market’s have evolved when recession is avoided.
That means if recession can be dodged, then we’ve likely seen the lows based on historical precedent as the current decline has been of similar magnitude and duration compared to past non-recessionary bear markets.
A decelerating rate of inflation is driving a Fed pivot to slower rate hikes. After hiking 0.50% in their last meeting, market implied odds currently favor a 0.25% rate hike at the next week’s meeting (chart below).
As a result, a less aggressive Fed is creating speculation of a soft landing for the economy. But I’m not convinced that a soft landing is in the cards just yet. Gauges of economic activity coming from PMI’s shows activity slowing, while leading economic indicators like the yield curve are triggering recession signals. The chart below shows the probability of recession using the 10-year / 3-month Treasury yield spread, and is the highest since the financial crisis.
So at this point, I don’t believe we’re out of the woods just yet with the stock market. As recession signals keep piling up, that puts the corporate earnings outlook in jeopardy. And as long as earnings recession is a distinct possibility, then it’s hard to believe the bear market is over.
But that doesn’t mean I’m not taking advantage of strength, especially when I see a rally accompanied by strong breadth and breakouts from sound bases. I just play more cautiously by reducing my position size compared to a more constructive macro environment.
And this year has featured several great long setups. We’ve had several wins in Mosaic Chart Alerts, and other breakouts are taking shape. That includes with energy-services stock PDS, which is attempting to breakout over a resistance level at $85 that has held since April. The relative strength line is also making new highs in the bottom panel.
And here’s an update on ETD that I included in last week’s Mosaic Chart Alerts. The stock is setting up favorably just below the $30 resistance level.
On the short side, weakness in solar company SPWR is taking the stock below key trendline support on heavy volume. Also note how the MACD has reset below the zero line, which means downside momentum could pick up.
That’s all for this week. We should know more about the earnings picture as the 4Q earnings season progresses and corporate outlooks are released. But it’s hard to get too excited given the state leading economic indicators and their message about the likelihood of seeing a recession.
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Disclaimer: these are not recommendations and just my thoughts and opinions…do your own due diligence! I may hold a position in the securities mentioned in this newsletter.