The first half year of 2023 has passed and after a rough 3Q22, we saw the markets take an upward swing. So, is this a new upside trend, or are we in a long correction inside a larger, maybe year-long correction downwards or sideways?
In my 2Q23 update I predicted a market uptick. However, when the S&P500 (the optimal corrective objective in our general market barometer) sailed past 4315/4325 in an unexpectedly swift and ample manner – with a dynamic that usually happens in a trend move – I had to ask myself whether the state and structures we anticipated were right or wrong.
The fundamentals have certainly been shining on the US equity market. And most of the sunshine has been beaming onto the tech area, as a result of the AI story, and then because inflation started to normalise – stabilising yields – and a bit of the bear receded from macroeconomic growth outlooks, as they weren’t as grim as they could have been. This evolved into a broader rise, which is most welcome.
The optician’s test
That said, I’m going to try on a different set of spectacles now, so let’s run down the drivers.
Stocks are driven by their income, expectation, and discounting. You end up paying for what you expect to get and how you or the market discounts it. This all goes back to the omnipotent Federal Reserve and the mighty US dollar. The factors that drive the Fed are the US dollar, growth and inflation, but which one drives the other?
Expansive fiscal policies globally have influenced growth positively. Inflation is currently on a downward, normalizing trajectory, driven by lower energy prices and lower used car prices; but don’t expect this to carry on.
I am of the belief that the United States will revert to its long-term inflation level of around 3%, and the inflation levels of 2% that we saw over the last 20-years were an outlier. As a disclaimer, I do realise that the trend towards outsourcing and robotics, and technological advances will continue to exert downward pressure.
What this means is that Fed short term yields are close to where they should be for now, and US Treasury longer term yields still have to decide where to go; a move that will impact all asset prices. Of late we have seen the Fed’s chairman, Jerome Hayden ‘Jay’ Powell encourage the Fed to take a ‘skip’ in its efforts to contain inflation. This has led to a weakening of the US dollar.
Weak dollar good for markets
A weaker dollar is generally good for financial markets, and this was the first positive feedback loop. The Fed slamming on the brakes also halted the US 10-year treasury yield rise, which was a decisive factor. The 10-year T-Bill yield moving above 4% recently was certainly a threat to the overall health of the financial markets. Fortunately, it quickly reversed back below 4%.
But to change the rising yield picture, 10-year yields must get below 3.68% before we can expect a good wind from that direction. Worryingly, should the 10-year yield break through last week’s ceiling of 4.09%, I’d be inclined to think that it could burn off the oxygen for the stock market, and apply upward pressure to the dollar; a bad thing for stocks and commodities. And, lest we forget, the impact of QT (Quantitative tightening, or ‘balance sheet normalization’ a monetary policy designed to contract or reduce the Fed’s balance sheet) and the USD1 trillion annual yield payment anniversary the US has in 2023.
Source: Tradingview – US 10-year Treasury yields on daily resolution with 300 days Moving AverageAs we can see above, the structure in chart of the US 10-year yield looks to be rising, since the move back from 4.33% has a sideways character. Moving averages are all pointing upwards, here shown by the 300-day Moving Average. With longer-term inflation expectations around 3%, a US 10-year yield is reasonable, but that also currently implies a -130-basis point curvature, which does not make sense longer-term, and indicates a recession. We will see which one is right.
Markets and charts
The S&P500 took a move up through the 4320 area quite fast. In technical terms, 4320 was the optimal structural and the mathematical corrective upward target as part of a larger and longer sideways-to-downwards move. It arrived at that point and then passed through it very fast, and also back tested the level successfully a few weeks later.
This has brought us up to the next target area of around 4505, again in our opinion both structurally and mathematically ‘right’. We are somewhat undecided as whether this is the potential corrective top; or a stop on the road towards an all-time-high. However, we are certain that the 4505-4576 mathematical target area will be significant, which is why we plan to reduce long positions and keep concentrating our position into the larger cap stocks.
We may have hit the top, but the final proof as to if we have a top, is the market giving a selling signal, and to date that has not yet occurred. Breath numbers and oscillators are also still pointing upwards. Structurally we would want to see the S&P500 close back below 4325 before we have confirmation.
How to play it
Considering that it has been the Nasdaq, tech and AI that has driven the dynamics over the last three months, it would be worth looking into that chart also. Here we have met a significant mathematical Fibonacci upward target at 15858 Wednesday, which again calls for reducing risk. There is also structurally room for one more shorter impulse, but the risk is clearly to the downside.
Source: Tradingview – NASDAQ 100 on Daily resolution
Keep a close eye on the US yields, both the Fed and Treasury yields, but also the corporate and mortgage yields, there the sun is not shining as well as elsewhere, and quite often we find good leading indicators there. Another trigger could be a close in gold above 1985, more on that next week.
Take a risk and remember to wear sunscreen, both at the beach and in the markets, else you risk getting badly burned.
Have a great summer.