The Factory Daily Letter
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Last week was another brutal week for investors, and the backdrop for long-term investors remains challenging
But some signals under the surface that suggest a short-term rebound could be brewing
Last week’s equity market price action was once again volatile, this time sending the S&P500 swiftly to bear market territory (-20% from its high). This market, so characterized by volatility, and these down-days that far-outpace up-days, continues to weigh on investor sentiment - and indeed bringing them closer to capitulation. But we cannot yet speak of panic, for while long-term investors may have been repositioning in favour of more defensive areas of the market, they do not yet appear to have lost all hope and / or been forced to liquidate positions. In this regard, it is the relative strength of the mega-cap tech stocks we are watching closely: as long as these stocks continue to hold up, the market might just manage a rebound in the coming weeks. However, if they don't, then the declines could become even larger and panic sentiment result.
That said, after seven consecutive weeks of declines, a tactical relief rally remains a distinct possibility in our opinion – particularly as some positive signs emerged at the end of last week. Of particular note is that some of the more speculative corners of the market such as IPOs, high-beta stocks and the ARK Innovation ETF stocks for instance (which led the indices down in recent weeks) now seem to be showing signs of stabilization – and moreover have not fallen below their lows of 12 May. We think some short-term outperformance from these sectors could signal some returning risk appetite and could even prompt a relief rally in equities.
On the brink of a bear market
Since the March 2020 low, the US equity benchmark S&P500 index has been in a bullish channel, appearing to form a classic 5-wave Elliott sequence in the process. After it reached 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 nonetheless consistent with a bullish scenario that could still send the index back up towards the wave (5) target at 5,100:
The S&P 500 equally-weighted index is now outperforming the classic benchmark index in a sign of recovering strength beneath the surface
The chart below shows the ratio between the S&P500 equally-weighted index and its classic peer. The ratio has formed a bullish “inverted head & shoulders” pattern and recently broke the falling resistance line connecting highs since 2016. This positive price action could trigger further rise in the coming weeks and send it towards the target of the bullish pattern at around 97.
While the equally-weighted index’s recent outperformance may reflect the rotation out of growth towards value, it might also be down to the fact that a larger number of stocks may now have ceased their declines and be on the verge of rebounding from extremely oversold conditions. This might be particularly true for the most speculative pockets of the market, including unprofitable technology names, biotechnology stocks and IPOs.
The bear market leaders now appear oversold
The bottom chart of the two below shows in blue the evolution of the percentage of Nasdaq 100 stocks trading above their 200-day moving averages. This gauge is now well below 20, which historically has been considered an extremely “overvalued” level and consistent with past local lows.
Beneath the surface, some bubbles have already burst
In the chart below we present the performance of the Nasdaq 100 during the late 1990s (when the index rose parabolically before collapsing back to its 1998 level) together with the recent trajectory of the ARK innovation ETF.
The tech bubble of the late 1990s is frequently referred to as an example to demonstrate the various stages of a speculative bubble growing and then bursting, the latter in three main phases:
- After the initial phase of decline, a period of lateral consolidation established itself during which the bulls and bears confronted each other. Some saw the consolidation as a buying opportunity and others took advantage of the rallies to sell;
- Then, at the end of 2000, the price fell below its former low and the buyers capitulated which sent the price into a rapid and violent downtrend;
- The price finally stabilised in 2001 and 2002, when the index made a higher low.
While historical comparisons are always crude and awkward (and the context is never equal) it is nonetheless interesting to compare the evolution of the Nasdaq 100 with that of the ARK innovation ETF (frequently currently referred to as representing a speculative bubble vis-a-vis its composition – mainly stocks not yet generating cash flow but nonetheless trading at very high valuation ratios).
If we overlay the trajectory of the Nasdaq during the dot-com crisis and apply it as a proxy, the same suggests that ARK’s decline could now be close to its bottom:
Nearly 20% of the Nasdaq 100 have fallen 50% from their highs
The chart below gives us a visual on the violence of the bearish moves suffered by the Nasdaq 100 since the beginning of the year. Indeed, by the 11 May bottom, about 20% of the index had fallen more than 50% from their highs.
This however also supports the idea that the speculative bubble has already burst and that a relief rally from extreme oversold conditions may materialize in the coming weeks:
The more speculative corners of the market are outperforming again
From a technical point of view, the outlook remains challenging. However, in the short term, there are also some encouraging signals. Firstly, the more speculative stocks – those that have been leading the decline in the last few weeks - seem to have halted their declines and even managed to close last week outperforming the S&P500.
This is the case for the S&P500 high-beta ETF which remains above a key technical support at 60.7 (defined by the 38.2% Fibonacci retracement of its previous bull market). As illustrated by the lower chart of the two in the image below, the ratio of high-beta stocks to the S&P500 has also touched long-term support and appears to be on the verge of breaking the falling resistance line that has connected prior highs since last summer.
A break of this resistance and some outperformance of high-beta stocks would be a positive sign that risk appetite is returning and thereby indicate/support a relief rally in the market:
Friday 13th’s big reversal stocks have held relatively well, with most still above their 12 May lows
In this context we can also point out that the majority of the stocks we highlighted in last week’s Technical View “Friday’s tactical turnaround” did not make new lows last week. This is interesting in our opinion as it indicates that the weakness in the price action last week could be more related to specific factors (such as the heavy penalization of certain consumer stocks on disappointing earnings) and that beneath the surface some encouraging signs have nevertheless emerged.
We think it is these "turnaround" stocks that have attracted the most interest from the bottom-fishers and in our view they continue to present potential opportunities for tactical investors who would like to be ready to take advantage of a relief rally in the equity market.
As a reminder, the table below shows the stocks in the S&P500 that saw the greatest price reversals on Friday 13 May (comparing the Monday-Thursday performance with Friday's performance). We added a RSI filter (< 55) to our screen to ensure stocks selected are not too overbought, and applied a PTS global grade filter (> 50 to catch those with the best combination of growth and quality:
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