The Factory Daily Letter
Please read important disclosure information at the end of the document. It is reserved for the exclusive use of the recipient. This document is intended for distribution to professional clients, accredited investors, expert investors and institutional investors only and not for distribution to retail investors.
Friday was a reversal day. Has the relief rally more upside?
The technical view
Economic momentum has continued to weaken
From an economic point of view, growth concerns failed to dissipate last week - as Chinese activity data continued to disappoint. Thanks to this latest wave of Covid-lockdowns, consumer spending and industrial output has hit the lowest levels since the pandemic began and despite the measures being put in place by Chinese officials in an attempt to support (including the recent cut in interest rate for new mortgages), investors remain cautious about the economic outlook – and are likely to continue to do so as long as China persists with its so-called Zero-Covid policy.
The US Empire Manufacturing index, one of the first data points for the month of May, came out yesterday with an unexpected drop to -11.6 (from 24.6 in April and way below market forecasts of 17). While a monthly survey of manufacturers in just New York State, it nonetheless suggests that manufacturing activity is likely to continue to slow in the rest of the US and that the negative trend in the data more broadly may be gaining traction.
There are several reasons to believe that the Fed does not need to be as aggressive as the market currently sees it. Historically, the Fed has always managed to avoid raising rates when the economic momentum has been slowing
As we discussed in our recent letter on the ISM cycle, the momentum in business activity already appears to have peaked and it has now even started to slow in the US in a manner that could ultimately dissuade the Fed from its pursuit of such an aggressive hiking trajectory as that which is currently envisaged (as such would put further downward pressure on the economy risking a so-called hard-landing).
The chart below illustrates how the Fed’s tightening cycle has in most instances resulted in a period of contraction for the ISM manufacturing index (the monthly indicator of US economic activity based on a survey of purchasing managers at more than 300 manufacturing firms). In 2016, economic activity still managed to improve for few months following the start of the tightening cycle, but the economy was also in that instance being supported by the significant fiscal measures that had been introduced by Trump during the early stages of his mandate. Moreover, it also appears that in all instances the Fed has managed to rise interest while the economic cycle has been expanding. Since 1980, never has the Fed raised rates when the ISM gauge has been decelerating.
After one of the worst starts to the year for the S&P500 index, the key question remains to what extent the worst-case scenario has been priced in?
The chart below illustrates the 20 worst starts to the year the S&P500 has suffered in its history: at -15.0%, this is the 4th worst YTD performance the index has recorded since its inception:
How have equity markets performed following poor starts in the past?
We present the data below: across the 20 worst starts to the year the index has enjoyed positive price performance through the rest of the year only 53% of the time, with a median performance of 0.93% from 15th May to the end of the year:
Friday was a turnaround day (down over 4.9% until Thursday before rallying 2.4% on Friday).
In the short-term, the index has been showing signs that a local bottom may be forming. From a technical perspective, the price formed a bullish “morning star” after extreme deviation from its 50-day SMA.
The chart below shows how the recent selloff drove the index below 2-standard deviations from its 50-day SMA before the late Friday rally drove it back into the Bollinger Bands. This reversal from extreme oversold may offer some impetus to the relief rally and drive the index towards the prior supports between 4,050 and 4,160. The 50-day SMA is currently holding at 4,331.
From a technical perspective, the price has formed a bullish “morning star” pattern, a bullish candlestick pattern that can signal potential recovery or the start of a new uptrend:
A strong Friday following a bad weekly start has historically been consistent with local bottoms
Equity markets have been rebounding since Friday. The performance follows 7 consecutive weeks of declines and with no particular news trigger. Whether this is a rebound or a major bottom, we think the relief rally could gain strength this week.
From a technical standpoint, the S&P500 was approaching bear market territory before Friday’s rebound. Many are looking at Friday's price action as an indication of changing sentiment. Typically, the strong gains that occur on Friday after a very negative start to the week are either hedges of short positions (short covering) or the result of new positions from investors who believe the worst-case scenario has been priced in.
The chart below shows the historical average (red) and median (blue) moves in the S&P500 following instances when the index has risen more than 1.5% on the Friday following a start of the week down more than 4%. Since the index’s inception, we have identified 22 such occurrences and on average across these events the index has thereafter rebounded about 5% over 60 days (with 64% of positive occurrences).
On the technical chart the S&P500 is testing the 50% Fibonacci retracement of the wave (3)
Since the March 2020 low, the US benchmark has been in a bullish channel, and appearing to form a classic 5-wave Elliott sequence. After reaching a high of 4,818 in January, the selloff sent it below a series of supports, including the 200-day moving average and the lower end of the bullish channel (invalidating our initial scenario of a minor pullback). In our new scenario, the wave (3) target has been brought forward from September 2021 to January 2021, putting the wave (4) target between 4,110 & 3,892. Despite the deteriorating technical outlook, the recent consolidation is consistent with a bullish scenario that could send the index back up towards the wave (5) target at 5,100:
The conditions for a bit of bottom-fishing are in place, but long-term investors may need to see more catalysts to encourage them back to the market
It remains our view that the market's expectations for monetary policy normalization have gone too far and that there is reason to believe that the Fed could revert to more of a wait-and-see stance in the future. We remain of the view that Fed is "behind the curve" and that the negative effect on the economy of doggedly-aggressive policy could become too great.
That said, inflation has become the Fed’s priority and moreover, while the latest CPI data showed a decline on a year-on-year basis, the pace of the decline has been slow. The risk of stagflation remains significant while prevailing geopolitical tensions mean that energy prices could continue to be subject to unpredictable spikes. From a geopolitical perspective, Finland and Sweden's applications to NATO are exacerbating tensions with Russia which is now deciding to reduce energy supplies to a number of European countries.
We are also yet to see a catalyst strong enough to support the market (a ‘dovish hike’ from the Fed, another strong earnings season etc proving so far insufficient to prop up sentiment) while the current high volatility continues to put off longer-term investors (who may prefer a more defensive approach favoring utilities and commodities to limit the degree of downside in the event of a larger market pullback). Lower levels of volatility and greater liquidity, coupled with a stronger catalyst, are needed to attract flows and encourage medium-to-long-term investors to return to the stock market.
That said, we will continue to look for tactical long opportunities when and where conditions look extremely oversold and key technical support levels are tested. But these opportunities should, in our view, remain very tactical in nature for the time being - and any such strategy should be designed to exploit what may turn out to be a series of short-lived relief rallies.
Friday’s big reversal stocks that are not overbought may offer tactical opportunities
We have identified the stocks in the S&P500 that saw the largest reversals last Friday (if we compare Monday-Thursday performance with Friday's performance). We have applied an RSI filter (below 50) to screen to capture those that are not too overbought, and applied a PTS global grade filter for those above 50 so to catch those with the best combination of growth and quality. See the results below:
Banque Pictet & Cie SA
Pictet Trading & Sales
Route des Acacias 60
1211 Geneva 73
Tel +41 58 323 2323
Fax +41 58 323 2324
Should you require any further information, please contact the team
Tel +41 58 323 1250
Email to: email@example.com
Disclosure and Disclaimer information is available by consulting the following link: https://www.group.pictet/strategy