The Market Mosaic 2.12.23
Is the bear market finished hibernating? A gulf in present versus future conditions, and what it means for stocks.
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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Now for this week’s issue…
Following Federal Reserve Chair Jerome Powell’s comments on interest rate policy last week, stocks jumped over 2% in a single day...then proceeded to give it all back.
The S&P 500 ultimately finished its worst week since December, with the reaction showcasing a struggle between the current state of the economy versus the outlook.
Strong data regarding the labor market and consumer spending points to an economy doing just fine. But that’s pressuring the Fed to keep a restrictive monetary policy and prevent inflation from roaring back. The fear is that the Fed goes too far and breaks something in the capital markets or economy.
The challenge for investors is knowing whether the “soft landing” scenario unfolds, or if something much worse develops. I can hardly recall a time when the gulf between present conditions and the outlook were so wide. You can see that in the chart below with the Conference Board’s consumer survey of current conditions and expectations of what’s ahead for business conditions.
But rather than being sucked into one particular narrative about what the stock market should do, it pays to be objective. And I do so by analyzing how the stock market’s trend is intersecting with internals and macro signals.
Here’s what the weight of the evidence says about the state of the economy and next move in the stock market.
A Mixed Message for the Stock Market
If there was ever a time of mixed messages for the stock market, it’s now. That’s because of conflicting evidence from macro indicators about what lies ahead versus the message coming directly from markets.
Lets start with the latter. In last week’s Market Mosaic, I showed you how to utilize sector performance to take the temperature of the economy and stock market. More specifically, cyclical sectors are doing things you’d normally see in a bull market by leading the way higher.
The price action in January was also strong enough to trigger breadth thrusts and generate a positive long-term signal among stocks making new highs on the New York Stock Exchange. That type of action suggests serious buying by institutional investors, and not just short covering that marked the low quality rallies of 2022.
Furthermore, relative calm has also taken over the high-yield bond market. High yield spreads reflects the extra compensation that investors demand for taking on the risk of lending to companies in poor financial condition. After spiking into mid-2022, spreads have continued to slide lower which indicates less concern about the state of economic conditions on financially vulnerable companies.
But leading indicators paint a much different picture of what’s to come. There has been no improvement in metrics like the yield curve, where inversion is pushing recession probabilities to the highest levels in 40 years as I posted below:
And if leading indicators are correct in their forecast for recession, then the primary risk for stocks is a move to fresh lows driven by falling corporate earnings. Using those indicators, Morgan Stanley’s model suggests that earnings could fall by approximately 25% as shown in the chart below.
That’s why the stock market is battling conflicting signals at the moment. While some point to a new bull market underway, others suggest that the worst is yet to come. Here’s how I’m handling the mixed message.
In the near-term, I would not be surprised if more downside emerged in the stock market. Deteriorating breadth and excessive bullishness (a contrarian indicator I covered last week) is a recipe for losses as I noted in this post:
But before you get overly bearish, please remember that pullbacks are common even in bull markets. After all, the S&P 500 averages three pullbacks of 5% every year on average.
I would also highlight another important character change in the stock market I’ve noticed compared to last year: there are an expanding number of breakouts holding their gains.
I pay close attention to the action in stocks on my watchlist and those I’m holding from pattern breakouts. Not only are more stocks breaking out, but they are also consolidating above key short-term moving averages (like the 21-day MA) even as the S&P 500 trades weaker.
I have a hard time becoming too bearish on the outlook with that kind of action, which brings me to another point. An advantage of my trading strategy is that it keeps me invested when times are good, and cash heavy when times are bad. If a breakout fails or price trends weaken more broadly, my cash position naturally rises.
For new setups, I’m turning my attention back toward commodity-related sectors. Constructive action last week even as the broader market dipped is a great sign of relative strength, and there are several chart patterns I’m watching.
That includes energy services stock RES, where I’m watching for a breakout over the $10 level to complete the chart pattern below.
To play the downside, I’m focusing on stocks illustrating relative price weakness that are breaking key support levels. That includes the setup with RUN, which is just starting to move below trendline support at the $23 level.
That’s all for this week. While most investors will be focusing on the latest CPI report on consumer inflation due out on Tuesday, I will be paying attention to the action happening under the stock market’s hood and the implications for building on this year’s gains (or not).
I hope you’ve enjoyed this edition of The Market Mosaic, and please share this newsletter with your family and friends…or anyone that would benefit from an objective look at the stock market.
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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.