The Market Mosaic 9.11.22
The stock market's tactical window has opened. This chart holds the key to the next big move.
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…
The situation certainly appeared dire to start the week. The S&P 500 was coming off a slump that had already taken out key levels like the 50-day moving average and 4,000 price support. And weak market action looked set to continue.
But a sudden rally that unfolded on Wednesday sustained its momentum to conclude the week. That not only snapped a three-week losing streak for stocks, but those key S&P support levels were recaptured along the way. It seems that maybe a bear trap was sprung!
Despite the lack of a catalyst to explain the sudden move higher, I’ve been flagging extremely oversold conditions especially from a breadth standpoint. As I noted here last week, the McClellan Oscillator hit its lowest level since 2020’s bear market while the percent of stocks trading above their 20-day moving average plunged to levels that have tended to mark a near-term bottom…here’s an updated chart of that metric below.
The sudden recovery didn’t catch us by surprise, and the bottom line is that this tactical bounce has room to run while many long setups are still primed to breakout (more on that below). But I’m also considering the bigger macro backdrop, and whether this bounce is nothing more than a bear market rally or the start of a more durable recovery.
I’m watching one key chart in particular to tip the next big move higher or lower.
Is This Rally Just Junk?
I’ve written extensively this year about using signals from the fixed income market to help assess the big picture direction in equity prices. I discussed the implications of the most important U.S. Treasury yield curve here.
I’ve also reviewed the information contained in high yield spreads, and what that means for the economic outlook plus the impact on stock prices. To recap, the spread on high yield (or junk) bonds is the additional compensation that investors demand for lending to companies of lower financial quality.
These are the companies that would be most susceptible to a deteriorating economic outlook, and thus their ability to repay debt. So if the outlook for the economy is worsening, spreads increase as investors demand extra compensation for the growing risk of not getting repaid. Empirical research also shows that companies with poor quality characteristics underperform in their stock returns, which should come as no surprise! Here’s a long-term chart of junk spreads overlaid with the Wilshire 5000 Index:
Now I want to share a short-term pattern that I’m watching with junk spreads. In the chart below, you can see that spreads could be developing a “head and shoulders” pattern in technical analysis jargon. The key thing here is that completing the pattern with a breakdown would signal lower highs and lower lows…the definition of a downtrend.
If high yield spreads breakdown from that pattern, that’s a significant message that the “soft landing” narrative is gaining traction and the economic outlook isn’t as bad as it seems. And that would be a big boost to equity prices. I still have a hard time reconciling that view with key measures of the Treasury yield curve that remain inverted (or close to it), but I will evaluate incoming data as it evolves.
In the short-term, I expect the stock market bounce that developed last week to have more upside. Key support levels were recaptured and oversold conditions have barely worked off. Other indicators of risk sentiment have also responded favorably, like with Bitcoin. I posted recently about the breakdown from another bear flag, and the negative message for other risk assets. That turned out to be a bear trap instead, as price quickly recovered as you can see below.
So I still look to play a tactical bounce in share prices. I’ve talked a lot about the setups in the energy and value space, and those patterns are still developing favorably.
Stock in many other industries are setting up as well, like with ERII that I added to Mosaic Chart Alerts last week and updated here:
In another positive sign for risk sentiment, I’ve also noticed several IPO bases taking shape. For me, I prefer to let an IPO “season” by allowing around 12 months of trading from the offering date before considering a trade.
DRVN is a great example of what I look for. As you can see in the weekly chart below, the stock went public at the start of 2021 and has since created a nice resistance level around $34/35 to monitor, which is my breakout level.
Despite my bullish tilt, I’ll conclude this week by saying be prepared for anything. With the fall football season back in full swing, I would compare my strategy and approach to that of a good defensive linebacker… read and react to what’s happening! Staying objective and flexible remains key in this market as the various monetary and geopolitical elements impacting stock prices remains fluid.
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.