Intoxicated

”No, I had like two drinks...Three max…Four now that I’m tallying.”

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Yes, history rhymes; the key is knowing when it starts to slur its words.

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Key takeaway: Questioning of the slowing inflation narrative has begun even faster than we expected. A two-step stock process must occur before the market tops, as identified in the Markets section. Retail Sales jeopardizes bank loan officers’ improving loan demand expectations. Similarly, Cisco customers’ slowing orders could underline a lack of commitment regarding the highly anticipated AI buildout.

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Sentiment Higher for Longer Dept: There have been no shortages of market analogs lately. There is a plethora of comparisons between today and the stock peaks in 1929, 1987, and 2000. I illustrated one last week with a CSCO and NVDA stock price overlay. There is another analog that came to mind when I looked at the CNN Fear & Greed Index.

The Fear & Greed Index is comprised of eight indicators (including the Put/Call ratio, the VIX, New 52-week highs vs. lows, and High Yield bond spreads) with a reading exceeding 75 classified as the Extreme Greed zone. I have highlighted the similar topping patterns in the data above. There is a similarity between the sustained optimism from seven months ago and today.

The daily chart of the S&P 500 below has two black arrows that align with the move into the Extreme Greed region that occurred in June and December. The red arrows mark the analogous dates where the pattern topped on July 26, 2023, and Friday’s close last week. Both rallies are remarkably similar: each produced a 6.5% rally from the time the index first hit extreme bullishness, and the current uptrend has lasted about the same number of days as the June/July rally that unfolded during the period with the same high sentiment readings.

Analogs are only good as a backdrop, not as a primary signal, meaning that an investor must wait for price action to begin to drop. However, if the June/July 2023 analog plays out exactly, then there could be one more top into mid-week before the reversal. The interesting facet of this analog is it signals a top coinciding with the NVDA earnings release Wednesday.

Aside from the coincidence between the current market and the July 2023 top, the fact is that we have lived with extreme bullish sentiment for two months that approaches the upper boundary of market exuberance. We have already had to deal with “higher for longer” with the Fed, now we have it (once again) with investor optimism.

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Fed Forecasts: Changing from a March Cut, Now It Is June. Going Once, Going Twice…

Market expectations are now closer to the Fed view of 3 cuts than the original consensus view of 6 cuts in 2024. Now the market expectation is for slightly less than 4 cuts this year. The next relevant dates that could affect this forecast before the March 20 Federal Open Market Committee (FOMC) meeting are at 8 pm February 27, when the Reserve Bank of New Zealand may hike rates for the first time since May 2023, followed by the February 29 release of PCE data. Of course, in March we have nonfarm payrolls, the Employment Trends Index, and CPI before the FOMC meets again. The March 20 meeting will conclude with the FOMC’s updated 2024 rate cut forecast.

A potential complication that could put the focus back the Treasury General Account in the case of a government default starts as the House returns from vacation on Thursday February 28. That esteemed body will have a total of three days until Saturday March 1, to deal with the first tranche of the Continuing Resolution. Most likely the lack of time to agree on anything will result in another postponement, but it could be a major source of volatility. We will discuss the budget situation next week.

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Stagflation Green Shoots

Growth?

1)??? The most important data releases for me last week were not CPI and PPI, but Retail Sales and Cisco earnings. Q3 consumption data set the bar high last year as it registered almost 5% growth, but Q4 will be closer to 3% given the downward Retail Sales revisions in November and December. Morgan Stanley estimates that Q1 will be 2%. From the January Retail Sales report, the Control Group (excluding autos and gasoline, restaurants, and building materials) contracted by -0.4% versus the +0.2% consensus view. A 2% consumption forecast for Q1 is not recessionary, but the speed of the downward revisions from 5% growth to 2% is far from encouraging.

Advanced Retail Sales growth has moved back toward zero, and is comparable to the profiles that existed before the last three recessions:?

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1)??? Cisco, the NVDA of 2000, reported earnings on Thursday, and the company dropped their second half revenue projections from -4% to -9% partly due to the stunning -40% y/y drop in enterprise orders. It is possible that Cisco’s customers’ orders have temporarily been suspended due to strategy backlogs as they form their final AI operating plans. Incomplete planning may be the true cause before they place explosively large orders. However, it could be a negative indicator about the remainder of 2024 demand. Earnings visibility is clearly lowered, and it may be indicative of a lack of enthusiasm over the economics of AI rollouts.

It is a testament to the prominence of AI optimism that the biggest macro release this week will be NVDA earnings.

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Deflation?

The Bank of America Global Fund Manager Survey reveals that investors have moved too much to one side of the boat: 90% expect lower short rates, and 77% expect lower inflation. Just 4% are factoring in higher inflation, with 7% forecasting higher inflation:

?Note that aside from the depths of the GFC selloff, low-rate expectations were also prevalent at the market tops in late 2000 and 2007 (see the light blue line).

In my variable dimensionality approach, higher inflation may be trying to kick its way back into the top three market drivers that form investor sentiment. It is very early to say that, but remember last week I had written:

“Assuming ANZ bank’s rate hike forecast is correct, it is important because the RBNZ tends to lead global central banks in monetary policy. A rate hike could mean U.S. markets push out their rate cut forecasts and become sensitive to the possibility of renewed rate hikes. Keep a watchful eye on February 27.”

Well, we didn’t have to wait for February 27, thanks to the CPI report.

More specifically, the market had a problem with core services strength that was always a risk thanks to positive real wage growth. This will get the market concerned over the aforementioned February 29 PCE report. PPI also came in above the highest analyst’s estimate across every category.

ISM services prices in January rose to 64 and is back to Q1 2023 levels. The ISM services series troughed in June 2023 at 54.

The Cleveland Fed’s measure of sticky CPI is rising on a 3-month annualized basis.

Sticky CPI above (read: services inflation) hit its nadir in July 2023, one month after ISM Services Prices bottomed out. July 2023, coincidently, was the month when the Fed logged its last rate hike. Since then, the central bank not only remained on hold, but has now formally removed its tightening bias. Services inflation is the one price gauge that concerns them most, and it is continuing to rise from its July lows.

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C&I Conundrum

The Fed’s Senior Loan Officer Opinion Survey (SLOOS) revealed that those loan officers expect Commercial and Industrial (C&I) loan growth will strengthen this year. The annual C&I loan growth so far does not give any evidence of a turnaround: data for January showed a drop of -1.7% y/y. Here is a chart going back almost 80 years.

Annual loan growth tends to go negative after recessions (see yellow vertical lines) as in 1949, 1953, 1958, 1975, and 2009. Only in 1990 and 2001 was it coincident with a recession. Now, the last three months, November, December, and January 2024 have been negative and are getting worse. There have been recessions in 1960 and 1970, 1980, and 1981/82 without negative C&I loan growth. Currently, banks have pulled in their business to the point where we have a situation of negative loan growth, but no recession. Either we are on the precipice of a recession, or this time is truly different. Because banks are expecting an increase in loan demand, the monthly C&I numbers are going to be a particular focus of mine.

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Two Potentially Bullish Counterweights: Chinese Liquidity and Seasonality

The Chinese government has been the major equity buyer recently, so they may be providing liquidity for institutions and retail customers to sell into. The question is whether they first need to address the property developer overhang more directly to turn the equity markets up, or is the liquidity add now sufficiently big enough to do the job. The CQQQ China Tech ETF has outperformed QQQ steadily this month after a severe 12-month underperformance. We will be watching Chinese markets closely this week, especially post-NVDA earnings for more clues.

China Quantitative Easing: The People’s Bank of China’s balance sheet is being inflated aggressively, as seen by the next chart.

The sharp acceleration has not helped equity markets proportionately but may be setting a positive backdrop. Since mid-2023, Chinese Central Bank Claims on Other Depository Corporations has increased by about RMB5 Trillion, which is about the same amount that was added during the 2016 rally. I would add that back then, the markets had bottomed in mid-February 2016, before the bulk of the liquidity was added, but the markets currently have been falling despite the RMB5 Trillion already injected. Depending on the index used, the selloff is currently more severe than in 2015.

Another potential positive is that the U.S. presidential cycle turns bullish in March. One can argue that there is uncertainty surrounding the 2024 elections that could make this year an outlier. However, along with rising liquidity in China, the seasonals do make it possible that there will be a favorable environment in 2024. Not my base case, but something to be considered.

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Markets:

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Equity Market: Texas Two Step for a Top

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Weekly Trend: Bullish

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Technically, five things become clear to me when I look at this updated hourly SPY chart from last week:

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·???????? The mechanical bid to buy the dip has been present (see BTD labels on the oscillator in the lower portion of the chart).

?·???????? The rallies from the January 17 and January 31 lows have been almost identical in size (see first two blue arrows), so if this current rally is consistent, it targets 5120 in the S&P. However,

?·???????? The 5030 price target (the 2.618 extension line in red) has acted as significant resistance. Rallies last week have not pulled far above that level.

?·???????? I will be watching to see that when the next time that the BTD level is hit, it results in a corrective, overlapping move up rather than an impulsive 5-wave rally. If we only get a 3-wave bounce and then make a new low, that will be a bearish outcome.

·???????? Support at 4925 (black dotted horizontal line) was resistance in late January at the 1.764 extension and is now support in February. It is critical to move below 4925 in the S&P 500 index to signal an initial trend reversal, but the real break comes on a sustained move below 4800.

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Two Steps Before a Turn:

1.??? Determine when AI enthusiasm has turned. The strength in QQQ relative to SPY can be seen in the daily chart of the ratio shown below. The green dotted line highlights that the ratio moved above the old 2021 high this January, and just dipped back below. The black arrows show how the ratio has been steadily bouncing off support. We will be watching this support closely into and after the NVDA earnings on Wednesday the 21st.

2.??? Examine the S&P chart to determine if it too has reversed on an absolute basis. Once QQQ/SPY turns, if the S&P 500 hourly chart above continues its upward trend, then we may experience a healthy rotation. If it turns down, first below 4925, and then below 4800, we will have confidence an important top has formed.

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Take note that the magnificent 7 averaged a -1.5% loss last week despite the NDX hitting a brief new record high Monday morning before reversing (TSLA +3.3%, Meta +1.1%, NVDA +0.6%, ?AMZN -2.8%, AAPL -3.4%, MSFT -3.9%, GOOG -5.7%).?

Is Cisco back as the swing player?

Last week I overlaid NVDA’s stock price with CSCO, showing the similarities between Cisco’s 2000 peak and NVIDIA’s current pattern. Looking at the CSCO weekly chart going back to the 2018 lows, it reveals a large head & shoulders pattern, which is formed as cycles of related harmonics top out. The large green circles map out the head in the center and two lower shoulders on the weekly chart.

Looking at the right shoulder, a fractal is forming, meaning that it has also formed a head & shoulders pattern as seen by the red ellipses, which is more evident if we were looking at a daily chart. Furthermore, looking at the daily head & shoulder, the right shoulder is forming its own head and shoulder bearish pattern (see the black circles). If we were looking at an hourly chart, that pattern would be easier to distinguish. These nested bearish patterns are, well…bearish (yes, I know, brilliant inductive reasoning…) but they need to be confirmed with a break below 48 and then 45. I will be watching closely before and after NVDA earnings on Wednesday.

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Finally, echoing the CNN Fear & Greed Index, the July top in the Nasdaq 100 is analogous to the current price pattern, and shares similar internals. Back in July, the percentage of stocks in the NDX that were above their 50-day moving average was 87%. The high reached in December was even more extreme at 92% (only 8 stocks were below their 50-day moving average). Just before the turn down in August, the number of stocks above their 50-day moving average was at 65%, and Friday’s reading dropped to 60%. Seasonality and my cycle model point to a downward move lasting into early March, which fits the potential for a selloff.

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Fixed Income: Is the Yield Curve Dead?

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Weekly Trend: Bond Bearish

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Ever since the yield curve inverted when the yield on the 2-year Treasury note moved above the 10-year Treasury note in the second half of 2022, talk began about its recessionary forecasting power. As it turned out, that recession never established itself.

?Let’s examine why it is still relevant.

?First, the chart below shows that the curve started a steepening move to reverse the inversion during H2 2023. It rose from -100 basis points toward -20 basis points (bp). I have always contended that the historical prerequisite for a recession was a move back to a positive slope after inversion. Because the curve has remained inverted, it is still possible that a flip back to a positive yield curve could signal an impending recession.

We did get a steepening trigger in Q4 2023 (see black arrow on the right of the chart above), but investors continue to sell the 2-year note faster than the 10-year note when the slope nears -20 bp, causing a re-inversion. A longer-term resolution would come on a weekly close above -17 bp or below -40 bp as noted in the chart. As for now, I view the recent consolidation in the yield curve as noise between -17 bp and -40 bp.

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?Second, don’t ignore the yield curve. There is a lagged relationship of 2? years where an inversion in the curve creates a strong potential for a sharp rise in the VIX. The peak in the 2s 10s yield curve in March and October of 2021 forecasted a VIX bottom in September 2023 and March 2024 before a sustained move higher. The two major VIX lows have been 12.7 in September 2023 and 1.8 in December 2023. These types of relationships are never precise, but the yield curve inversion warns of a regime shift to a higher volatility environment in spite of the current complacency.

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The 10-year weekly fixed income model remains on a sell signal with a second consecutive positive trend bar on yields, and the 4.28% close Friday remained above 4.12% support.

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A weekly TLT model has been consistently on a sell signal since January 2022, and would only reverse with close next week above 96.30 (vs. a 92.75 closing level Friday). This model is best traded as waiting for a second weekly signal before reversing to a buy. It is shown below:

?Crude Oil: At resistance

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Weekly Trend: Bullish

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?Bloomberg reported that OPEC’s top official was bullish on global oil demand and said that “OPEC+ will continue to be very preemptive and proactive.” This reinforced the market’s belief that there will be an announcement extending the production cuts that are due to expire on March 31, before the Joint Ministerial Monitoring Committee reconvenes on April 3.

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The International Energy Agency reported that 95% of the incremental supply increase expected in 2024 will come from non-OPEC+ suppliers and the group expects a slight contraction in global demand.

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The crude seasonal calculated over the last 20 years is bullish despite WTI crude futures banging against the strong $78-$80 resistance zone:

Natural Gas seasonality also forms a double bottom in February and March, which would be welcome news for longs since the commodity has fallen over 50% from its early January highs toward $1.50. We are scraping lows going back over the last quarter century.

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Peter Corey

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PavePro Team

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