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Once again there are too many bears
Similar to how markets were positioned in June, we are again reaching a point where this sell-off may be showing its age, with several market indicators pointing otherwise A bear market rally may be imminent. Indeed, bearish sentiment and market positioning have once again reached levels where further downside appears unlikely in the near term, despite the fundamental and macroeconomic case for such an outcome.
From a technical perspective, the renewed bear market since the outright rejection by the 200-day moving average that marked the end of the summer rally in equities has seen equities trade back down to the June lows, with that area at around 3,650 is S&P 500. Happily, this support area has held so far and has been accompanied by a sequential 9-buy signal from DeMark and perhaps a slight positive divergence in momentum according to the RSI.
The same applies to the Nasdaq. This test of horizontal support appears to be an excellent starting point for a needed countertrend rally to an oversold stock market.
Although the technical picture is nothing special, a countertrend move seems warranted given risk appetite, positioning and sentiment. Indeed, several metrics of investor risk appetite are perhaps most supportive of this view.
More notably than the June lows, this recent move lower in equities has now resulted in significant positive divergences in bond market risk appetite, the ratio of high-beta stocks to low-beta stocks, and that of cyclical defensive stocks. When measurements of market internals like these diverge from overall index price action in such a way, it generally does a good job of predicting what might lie ahead.
If we compare the price action of the S&P 500 to junk bonds (via HYG), the latter is doing a good job of guiding the former to local tops and local bottoms in the short-term. This week’s price action has caused junk bonds to diverge positively from stocks, suggesting the sale may be complete for now.
Much like risk appetite is sending what appears to be a bullish signal, positive divergences are also beginning to show in several of the breadth measures I monitor. Notably, the percentage of stocks trading above their 50-day moving averages has returned to single digits, suggesting a short-term low is near.
Additionally, both the VIX term structure and the VIX itself appear to deviate positively from price, another indicator with a reliable ability to predict future price movements.
From a sentiment and positioning standpoint, by almost any measure investors are bearish and shorting the market (which I’m sure is nothing new to you, dear reader). In fact, the combined speculative positioning on the various stock futures markets is as short as possible. While this has been the case for much of 2022, at least some level of short coverage appears to be a requirement before we see stocks continue lower as fundamentals and macro conditions dictate.
One asset class that would lend credence to the idea of another short covering rally is a drop in yields. The new highs across the Treasury curve can be attributed to lackluster liquidity in the rates market, along with structural issues brought on by Fed tightening, dollar strength and persistent inflation.
Such dynamics may result in interest rates not acting as they should, or at least not as they have recently given the macroeconomic outlook. It is worth noting, however, that the new highs in the 10-year period were not confirmed by new highs in the momentum (measured here by price versus the 50-day moving average).
Similar to equities, the sell-off in bonds appears oversold (yields overbought) and due for a respite. From here, a drop in yields seems plausible, even if only temporarily.
In fact, returns can only deviate from fundamentals for so long.
Another would be the dollar. Like yields, the dollar appears to need a pullback or at least a consolidation of recent gains.
While I expect the continued strength and any correction to be short-lived for now, given the negative correlation of nearly all asset classes to the dollar over the past few months, a correction would certainly be some for not just equities, but precious metals and commodities as well bring relief.
However, it is important to consider some non-fundamental headwinds equities face over the coming weeks that are at odds with what I have outlined here. First, the next 10 or so trading days tends to be one of the worst periods for stocks on a seasonal basis, as we can see below. While seasonality should only be a small part of trading decisions, it does play a role and is a notable consideration.
Second, JP Morgan’s equity hedge roll is set to take place at the end of the month, which Tier1 Alpha says should result in $12 billion in equity futures sales this Friday. So we may go lower before we go higher (if at all).
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Editor’s note: The summary points for this article were selected by Seeking Alpha editors.
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