The Factory Daily Letter
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Is this the start of a new bullish trend or is it a bear market rally?
The technical view
A rebound after seven consecutive weeks of decline
In last week’s Technical View “Is something cooking?” we pointed out that while the market continued to sell off, something seemed to be changing beneath the surface. Of particular note was the fact that some of the more speculative corners of the market (such as IPOs and unprofitable-tech) had also more recently started to outperform, suggesting either that short investors had reduced their positions or that the bottom-fishers had started to buy on weakness (or of course, both).
It must be said that seven weeks of consecutive market declines and extremely bearish sentiment indicators made fertile ground for a rebound, and it was the ‘less-hawkish-than-expected’ FOMC minutes released Wednesday last week that allowed market participants to indulge the notion that a nascent relief rally could indeed gain some traction, as the narrative shifted to one of peak Fed hawkishness and inflation starting to pass into the rear view (Minutes contained discussion of a potential pause in September to see how the economy is adjusting to higher rates).
While there is some reason to support the idea that the recent relief rally has been in part due to month-end rebalancing and the cutting of short bets, encouraging signs have also emerged that suggest markets have put in a significant local low.
The bar chart below illustrates how last week’s rally erased all of May’s losses - indeed an encouraging sign that a local bottom has formed:
Our risk indicator reflects a rising appetite for risky assets
The chart below shows our PTS “Risk on/ Risk off indicator”, which is a normalized gauge of various risk appetite indicators, including the gold/copper ratio, the USDJPY currency pair, and the US small/large cap ratio.
It is currently rebounding from extreme risk-off territory, and has already returned within the -2 standard-deviation threshold, suggesting that investors are becoming less risk averse:
The recent risk-on market behaviour has been fuelled in part by a short-squeeze
As mentioned above, while the price action has been positive and accompanied by an improvement in risk aversion, we nonetheless given the current context remain cautious about the longer-term outlook and maintain a tactical approach to the equity markets for the time being.
One factor contributing to the fragility of this relief rally is that it is in part likely due to some investors temporarily cutting their short bets in anticipation of possible equity inflows associated with monthly portfolio rebalancing.
Below we present the performance of a theoretical basket of stocks made up of those names that have the most ‘contrarian’ PTS sentiment grade, and it includes the most heavily-shorted names. It illustrates how after another sharp decline at the end of April, it then declined again in May, before rebounding strongly last Friday (suggesting a closing of short positions):
So how far can this rally go?
From a technical point of view, the S&P500 may have completed its consolidation wave. In our view, the correction that started in January can be broken down into a classic zigzag correction and the low made at around 3,800 could mark an important local low before the positive momentum resumes in a new upward sequence: it corresponding to the wave (5) of the full bullish sequence of the post Covid-crisis period.
However, we are aware that in the current environment, a scenario of such a strong rise remains contrarian and were it to be validated such would involve this rally being strong enough to send the index above a series of intermediate resistance levels.
In the short term, the next technical resistances are at around 4,276 (the 50-day SMA). Longer term, the technical outlook will remain quite challenging (and negative) for so long as the index remains below 4,400 (a level at which the 200-day SMA and the upper band of the downtrend channel dating back to January meet). A break of this level could support a melt-up that sends the index to a new all-time high; while on the other hand a failed attempt to break through would suggest that the corrective phase is not over.
In any event, the risk/reward remains positive in the short-term:
The more speculative bets are on the rise
So while we think it is too early to consider a melt-up, signs are that in the short-term the speculative rally may have further to go. In this context, we think that investors should continue to favor a tactical approach and to favour the trades with the best risk/reward ratios.
Last week we pointed out that despite the poor stock market index performance, something seemed to be moving beneath the surface, particularly the fact that the most speculative pockets of equity markets, (such as IPOs and unprofitable technology stocks), started outperforming once again, suggesting that short investors had reduced their positions or that the bottom fishermen had started to buy on weakness.
The table below shows that among the most speculative stocks, the ARK innovation ETF has rebounded 23% from its recent low and recently surpassed its 10-day high (and the same bullish pattern is evident in “meme” stocks, IPOs and high-beta S&P500 stocks), while Chinese tech stocks and US biotech are still below their 10-day highs and offering the highest risk/rewards ratio, in our view:
US Biotech and Chinese tech looks on the verge of breaking out
From a technical perspective, the SPDR S&P Biotech ETF has formed a bullish “ascending triangle” pattern, and a daily close above the resistance at 71.50 would trigger a rise towards the breakout target at 83, a level also corresponding to the 50-day SMA and the falling resistance line connecting highs since January. On the other hand, 66 is a key short-term support:
Chinese technology ETF: offering an attractive risk/reward ratio
The same technical pattern has been formed by Chinese technology names. Looking at the Invesco China Technology ETF a daily close above the 50-day SMA (currently holding at 44.4) could trigger a rise towards the breakout target at 5 which is the target of the triangle breakout and where it meets the descending resistance line connecting highs since January, and also a level that has been reached twice in March.
On the other hand the a daily close below 41 would invalidate this positive scenario.
“Best Biotech and Chinese tech” names
It remains our view that the more speculative stocks have recently been attracting most interest from the bottom-fishers and that they continue to present potential opportunities for tactical investors ready to take advantage of a relief rally in the equity market.
While many of the more speculative pockets of the market have already enjoyed solid short-term returns, US biotech and Chinese tech stocks are still sitting below key short-term resistance yet appear on the verge of breaking out. Moreover, in our view they also offer the most attractive risk-reward ratio. On this basis we present below a selection of stocks within those sectors with the better PTS quant profiles (highest global grades) - and an RSI below 70 (to avoid overbought stocks).
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