The Market Mosaic 7.31.22
The Market Mosaic 7.31.22
Did Stocks Bottom? 3 Things to Know.
Welcome back to The Market Mosaic, where I gauge the stock market’s next move by looking at trends, market internals, and the mood of the crowd. I’ll also highlight one or two trade ideas I’m tracking using this information.
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Also, 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…
A few issues ago, I talked about how stocks are supposed to climb the wall of worry, and boy did they climb this week!
A slew of earnings reports, the Federal Reserve meeting, GDP report…there was plenty to worry about this past week along with lots of negative sentiment. That tinderbox was enough to spark another move higher in stocks, and we’re finally starting to see more leading stocks breaking out.
Like with ENPH from our watchlist that bolted higher following earnings:
GPC is another stock breaking out from its pattern that I originally highlighted here. After clearing resistance at $141, the stock is now up 8% in a week.
But I wish my list of breakouts was more expansive. Instead, a lot of the action has been in beaten up tech and growth shares coming off their lows, with the Nasdaq 100 (QQQ) and small-cap growth (IWO) leading the way.
I won’t hesitate to trade the setups I highlight in Mosaic Chart Alerts when they trigger. But I still suspect we haven’t seen the bottom in stocks just yet.
The key is to not get suckered by this rally. Here are three things to know right now.
Did Stocks Bottom? Three Things to Know
Understandably, the debate is raging right now on whether or not this bear market has seen its conclusion. Not only is the S&P 500 up nearly 13% off the June lows, but the Federal Reserve surprised investors with a dovish pivot at last week’s meeting. Perhaps signs of a recession with another negative GDP report are having an influence, while 2Q earnings haven’t been a complete disaster.
But instead of trying to sort through the headlines and guess if the worst is over, here are three key big picture items at the top of my mind.
#1: Bear market rallies are fast and furious, and make you think the worst is behind.
After last week, it sure feels like a new bull market is upon us…and maybe it is. But that’s also the nature of bear market rallies. They suck you back into the market just before separating you and your capital once again. There’s PLENTY of historical precedent. Just take a look at the chart below of the S&P 500 from the dot-com bear market during the 2000 to 2002 time period. A bear market is not a straight shot lower, and you can see numerous rallies that unfolded along the way. And some of those were incredibly powerful. I’ve highlighted three stunning bear market rallies that averaged 20% and lasted several months each! But after each instance, stocks rolled back over to new lows.
#2: The fixed income markets will let you know when the “all clear” has sounded.
I’ve recently discussed signals from the stock market to know that the bottom has arrived, including measures of capitulation followed by breadth thrusts. The picture here is murky in my opinion. Yes, there have been modest signals of both capitulation and thrusts following the June low. Personally, I don’t think either has been strong enough to suggest a bottom. I discussed this here.
So I’ll confirm if I’m right or wrong by following the fixed income markets. If the worst is behind us, then I want to see a couple things occur. First, high-yield spreads should turn sharply lower. At 3.3%, spreads on BB rated bonds are off the June highs but still trading in an overall uptrend.
Next, I would like to see yield curves move away from inversion. I’ve talked about my preference for the 3-month/10-year Treasury yield curve, and in each of the last five recessions this spread was already well into positive/steepening territory by the time the stock market bottomed. The chart below shows where we are currently, and how the yield curve had steepened during the bottoms around the 2000-2002 and 2008-2009 bear market. Steepening signals a dovish Fed and improving outlook for the economy (and thus corporate profits). But right now, this curve is still hovering just above inversion.
#3: You can chase, just don’t do anything dumb.
Just because I’m suspicious of this rally doesn’t mean I’m sitting on the sidelines. But I’m also not chasing stocks for the sake of getting invested. I have a well-defined process for selecting the best trading opportunities, and the point at which I enter those stocks. More importantly, I have a very strict process on cutting losses if things don’t work out! Staying true to your discipline and quickly cutting losses will help mitigate any damage if this turns out to be a bear market rally. If you want to know how I do it, check out the end of Mosaic Chart Alerts for my “rules of the game”.
Now What…
As I mentioned above, there has been an expansion in breakouts meeting my criteria, but not at a level I would expect with the S&P 500 rebounding over 12% off the June lows. There are still several ideas that I’ve flagged in Mosaic Chart Alerts with nice setups and are trading right at resistance.
That includes DY, which is again starting to poke above the $100 level. Those gains came on higher volume last week which is exactly what you want to see.
KNSL is another stock starting to emerge from a long-term basing pattern. Trendline resistance at $240 was taken out on Friday. The next level to watch is the prior high at $252.
It may seem counterintuitive, but this is also a great time to focus on short/put option setups. With the strong rally in stocks over the past month and a half, I’m looking at fundamentally weak stocks that have barely budged off their lows. Those are the stocks most susceptible to breaking down on another leg lower in the market.
That includes U that I highlighted in last week’s Mosaic Chart Alerts, and I’m following this pattern in TTD as well. The downtrend is still intact, where I would consider a position on a close under $41.
That’s all for this week! I hope you’ve enjoyed this edition of The Market Mosaic, and please share this newsletter with anyone you feel could 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.