The Factory Daily Letter
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The case for a summer rally
The poor equity market performance this year has done some serious damage to the trend. A handy technician will always be able to find new technical supports (ones based on longer-trends for example), however our own trend model indicated that the trend in the S&P500 was broken back in early March.
Trend following is not so much about timing the market, rather it is about trying to ride the bullish trends across the big rallies and moreover to avoid riding a bear market all the way till the bottom, fully invested.
The big drawback to systematic trend-following strategies is however that whipsaws can sometimes result in the buying back of stocks at higher prices than they were sold. But we use our trend model as a risk indicator that flags an unhealthy bullish trading environment after a broken trend has been flagged. It is straightforward and fairly consistent based on three different moving averages (60 120 and 200) which generate 10 different sub-signals aggregated to form the trend model. These include:
- The price position vs each moving average;
- The rate of change for each moving average;
- The position of a moving average vs each of the others; and
- The current price level over a specific range to see if we might be facing a local high or low.
As illustrated below, following these simple rules would have resulted in one being uninvested during most of the major long-lasting corrections and bear markets (shaded grey). But we are mindful that there are several instances of the market whipsawing in between which could have adversely affected performance were this to have been applied as a more tactical trading tool.
Nevertheless, the slow deterioration in the momentum since the beginning of the year is typically something that the trend-following model captures well, and our indicator indeed flagged a “broken trend” after the S&P500 fell -12.5% from its high on 8 March. Last week’s rally, powerful as it was, wasn’t enough to restore a positive trend.
It is difficult to argue against a model such as this that cautiously suggests one might remain on the sidelines. We are indeed facing one of the most challenging backdrops for equities since 1980 with inflation, rising yields, war in Ukraine and hawkish central bank policy all calling for caution on the macro front.
But the problem with buy-and-hold strategies is that they often miss out on big tactical opportunities. Even during bear markets strong rallies of +20% frequently occur, and so it is that today strategists are preoccupied with assessing whether or not conditions are ripe for a rally regardless of the fact that the longer-term trend may have turned negative.
Whether we are about to ride a new bullish wave or whether are on the verge of a bear market rally, the risk/reward in US equities is currently looking very attractive
The current economic and geopolitical context backdrop is as challenging as it is opaque, while from a technical point of view the indices now have to jump a series of key resistance levels before our positive scenario for the end of the year can be validated. However, even in the case of a bear market rally, the upside potential presents an attractive risk/reward ratio for tactical investors by placing a stop below the recent low.
The chart below shows the bear market in the Nasdaq 100 index that followed the dot-com bubble in the early 2000s, illustrating how during the correction phase, the index experienced at least 4 bear market rallies ranging between 17.4% and 49% trough to peak:
The missing piece: bull markets tend to end with a period of acceleration to the upside. If the bull market had really stopped in January, then the post-Covid rally would have been atypical
In the table below we present historical bull market data, each broken down into deciles, the conclusion being that the strongest period of performance within a bull market tends to be at the beginning and at the end (with a median performance of 13.6% and 10.5%, respectively). In this current (or recent) bull market the first decile has also been the best-performing period in keeping with this trend - with a total return of more than 83%, however returns have been lower more recently – the last two deciles (from December 2017) at 2.8% and 3.6%, respectively (the best performing decile being the 8th - that between 2016 and 2017). Such supports our scenario of a last bull run into the summer (i.e. its not over yet).
So is this current correction the tip of the iceberg or is there more unseen downside to come?
For us the answer to this question is no – and also perhaps. No because we think it is too soon for the market to fall straight on down from here. Earnings remain supportive (as evidenced by the recent reporting season), sentiment is extremely negative (a contrarian bullish signal) and the recent price action has not been characteristic of the end of a bear market (as we will discuss below). On this basis we consider there to be a good chance we see a rally this summer.
Perhaps this rally will however mark the end of the current bull market. As we said before, the current environment for equities is one of the worst seen since 1980. There is much uncertainty around the Fed’s ability to choose between the Scylla and Charybdis of inflation and recession. The market trend is now clearly negative and we doubt it will be able to maintain the current bull market for several years. A bear market is likely on the cards, but it is not imminent in our view.
Several indicators suggest the current price action does not reflect the market behaviour and characteristics of past bear markets
We recently discussed at length the degree of and implications of the poor sentiment in markets. Sentiment is still extremely bearish and the financial press is now preoccupied with recession risk, with policy tightening, inflationary pressures and the war in Ukraine are widely considered as among the key factors that could trigger a recession in the months to come. This is reflected in the number of financial media mentions of the word “recession”, which has skyrocketed since the beginning of the year, reflecting the evolution of negative sentiment. Note how peak mention of the word “recession” has historically tended to match S&P 500 market bottoms:
The recent price action is not characteristic of the beginning of a bear market: strong and rapid back-to-back rallies tend to occur during market major bottoming processes
Another sign that is typical of major lows is that the market price tends to rebound strongly in a short period of time. Using the 3-day Rate of Change indicator, we can see that the performance recorded between 25 May and 29 May is above 5%, which is more than 2 standard deviations from the historical trend and moreover is consistent with the levels that characterized previous major market bottoms:
Advance volume gained traction last week
Last week the S&P 500 index rebounded (closing the week 2.47% higher), after seven consecutive weeks of negative returns. Beneath the surface, the index has been supported by rising advance volume as a proportion of total, while the ratio between the two metrics has remained above 80% for three consecutive days:
From a historical perspective, an incidence of three consecutive days of advancing volumes as a proportion of total with the ratio between the two gauges above 80% remains relatively rare. Indeed, as shown on the graph below, last time such event an occurred was in March 2020 following the Covid market crash:
In the chart below we show the historical average evolution of the S&P 500 after 3-consecutive days of advancing volumes. While such levels of volume are not usually associated with bear-market rallies, they tend to precede further gains (the only exception being 2008 when the signal was a bit too early). Moreover, this signal has never before been triggered at the beginning of a bear market. Such indicates that the current risk/reward ratio is attractive.
In the chart below, we set current market behaviour against the average historical performance of the S&P 500 after three consecutive days of advancing volumes. Interestingly, the current evolution of the US benchmark has so far been tracking the average quite closely, in a manner that implies that we could see the S&P 500 rebound in the coming weeks:
In the table below we present the forward returns of the S&P 500 after 3 consecutive days of advancing volumes as a proportion of total, and the picture is appealing: average returns remain in positive territory from 1 week to 1 year after. After a month, the average return is 2.3% (and the median statistics even better at +4.1%). After six months, both statistics are relatively similar (around +12.5%) while the one-year return reaches more than 20% on average. Moreover, across the data the performance is positive between 70% to 90% of the time (the only negative returns data in the data relating to 2009).
The recent buying pressure has now spread across the market sending the MCClellan oscillator (the market sentiment and breadth indicator that is based on the difference between the number of advancing and declining issues on a stock exchange) back above 300 for the first time since March 2020. Every time this has happened in the past 60 years, it has marked the end of the selling pressure (or very close to it):
The chart below reflects how never before has such a signal occurred at the beginning of a bear market. In fact on several occasions, it has proven an indicator of a major bottom. As nothing is always 100% sure in finance, the signal in 1974 was triggered too early:
Out of the 65 such signals the indicator has sent over the past 60 years, in 59 cases S&P500 returns have been positive after a year, and the only period with a loss of more than 4% was the case of January 1974 (with a dramatic -32% after one year). Nevertheless, the risk reward looks particularly appealing over the medium term with more than 80% of returns positive:
We have also screened the historical data for those 100-day periods during which returns have been most closely correlated with the past 100 days. In most instances, the current period corresponds either to a local low or a significant bottom. Were history a guide to future performance, it would accordingly be telling us that a significant rally could unfold soon:
So has the recent rally invalidated the bearish technical scenario?
We have been maintaining quite a bullish short-term technical outlook through the recent market correction, arguing that the consolidation has been consistent with a temporary pullback before the uptrend resumed. That said, the more bearish technical analysts have been pointing out a bearish head & shoulders pattern formation as a clear sign of a major bottom.
Well, the index has now moved back above the neckline of this bearish head & shoulders pattern, and an upside break of the resistance at 4,170 could now invalidate the bearish pattern forcing the technical bears to reconsider their scenario:
Do the technicals still allow for a summer rally?
Firstly, it is our view that the market may have reached a significant bottom above 3,892, a level that corresponds to the 50% retracement from peak of the post-Covid rally. Our preferred scenario is that the recent move corresponds to the end of a corrective wave (4) and that we could be on the verge of a final bullish wave that could send the index back to its historical high.
Another positive signal (and as mentioned above) is the index moving above the potential neckline of the bearish head & shoulders pattern. The rally has sent it back above key resistance in a manner that should invalidate the bearish pattern and encourage the technical bears to reconsider:
Glimmers of hope
Historically, the summer period tends to be characterized by lower volumes and falling equity markets, (particularly June, which on a seasonal basis (and as we discussed earlier this week) is one of the weakest months for equity market performance). However, when you look at the outliers you realize that it is often at this time of year that significant market movements take place, both up and down.
In letter of a few weeks ago “Capitulation contagion” we discussed how the rise in interest rates had first affected a fairly contained part of the equity market before more evidence as to the ongoing persistence of inflation fuelled the upward pricing of Fed rate hikes triggering more widespread contagion to other more speculative pockets of the market (such as IPOs, biotech, unprofitable tech, the lockdown winners). Peak pessimism emerged just as the mega-cap tech index looked about to break key technical support (which could have resulted in capitulation across the broader market). We then saw the relief rally, the market recovering from oversold and extremely pessimistic territory and indices returning above initial resistance levels.
What is interesting for us is that now the same contagion mechanism appears to be unfolding in the reverse (bullish) direction. The prospect of peaking inflation (and possibly peak Fed hawkishness), coupled with the easing of Covid restrictions in China has been allowing the recovery across the more speculative parts of the market to advance. Accordingly, if this bullish (or less bearish) mood were to continue, inflows could return to the majors and fuel a much-needed summer rally. Moreover, and as we discussed yesterday, we think conditions are such that the same could be driven by cyclical names – see our screening of US cyclical stocks that are not overbought and appear to offer more upside potential again below:
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