The Fed Put was in full effect on Jan. 4 when Fed Chairman Jerome Powell said they could be patient at the American Economic Associations Annual Meeting. Investors were treated to yet another dovish catalyst last week. An article in the Wall Street Journal stated: “Fed officials are close to deciding they will maintain a larger portfolio of Treasuries than they’d expected when they began shrinking those holdings two years ago, putting an end to the central bank’s portfolio wind-down closer into sight.” The Fed has rallied the market thus far. Now what?
While the rally off the December lows has been substantial, may still want to see greater change. For starters, all of the major U.S. equity indexes are still set in long-term downtrends that were established after the October highs and confirmed by the December new low. Secondly, while the rally has been strong, we still lack two things to confirm a trend reversal: a higher low and a higher high. What the rally has done right is go up in all the risk-on areas:
The areas that have seen the worst performance relative to the S&P 500 are the defensive sectors (staples, health care, and utilities). A switch from risk-off to risk-on is a very big change in the behavior of the stock market, however, this is often typical in bear market rallies when the economically sensitive areas rebound the most. So while risk-on has been working, it’s still not the end-all-be-all indicator justifying the downtrend will reverse.
One example of a similar situation was in the 2015 rally that came right after the Yuan devaluation caused concern in the market. Back then the Purchasing Manager’s Index data for Chinese manufacturing was in contraction territory below 50. During the period following the stock market correction in August of 2015, risk on sectors led the rally. At the end of the rally conditions became overbought and the market fell again a month later to re-test those lows and finally bottomed because the fundamentals hadn’t changed.
Let me move away from risk-on versus risk-off to discuss two more issues I haven’t seen resolved in this rally. Energy still needs to develop a constructive bottom and credit spreads need to narrow.
Oil has fallen back into its 2016-2017 trading zone as bear investors took advantage of the OPEC misstep last year, first adding production ahead of Iranian sanctions and then removing that production. A rally has led it back to the top of that trading zone, but we don’t have a higher low (failure swing) yet to identify the makings of a trend reversal. The RSI has rallied to bear market resistance levels under 60 and is acting as a buffer to this advance. As oil is a barometer of economic activity, I’d like to continue to see a bottom develop in the commodity.
Secondly, I want to see credit markets agree with this rally. The spread between the yield on Moody’s BAA Corporate Bond Index versus the 10-year U.S. Treasury yield (charted in red by taking the inverse below) shows that the spread keeps widening, which is a heightened default risk measure we track. This spread (inversed) should be tracking the S&P 500. As equity prices rise on good economic activity so should risk spreads narrow. We currently don’t see this taking place in the chart below. The credit spread on corporate BBB debt bottomed last year at the onset of the global correction in equities while U.S. stocks got a second go of things on Trump’s tax cuts.
The S&P 500 is in a wait and see mode since breaking above the 50-day moving average and touching its resistance trendline from the October high and the December high at the end of the November consolidation.
The risk-on movement stalled as the market turned from oversold in December to overbought in January on a powerful rally. See below as 70 percent of the S&P 500 companies traded above their respective 50-day moving average.
We’ve seen some distribution and profit-taking at these levels, however, some of the drivers behind the growth concerns like the lower GDP print from China, the drop in exports from China and Japan and the lower PMI numbers last week out of Europe, Japan and the U.S. have not caused the bulls to tuck tail and run. Even disappointing results from Nvidia and Caterpillar yesterday barely scratched this rally. The dovish comments from Powell this month and the WSJ article last week have done a lot to steady the bulls, but now what? Oil, stocks and credit spreads all need to develop better bottoming patterns. Downtrends exist and have not been reversed yet. I don’t recommend chasing this rally if you’re out. Usually there’s a retest or small correction that can offer a better entry point.