The Market’s Character: “Am I About to Catch a Cold?”

Macro Analysis: Systematic risk is back on the menu. With the failures of Silicon Valley Bank and Signature Bank and the situation where First Republic Bank and Credit Suisse are on the brink of failure waiting for white knight saviors, the idea of a new financial crisis is on everyone’s mind. To restore confidence in the financial system, the FDIC insured all deposits, even those above the normal $250k limit, and the Federal Reserve Bank also provided a new funding line to banks struggling with liquidity and capitalization levels. Some believe that the banking issue was contained, however, others believe that the rapid rise in interest rates over the past year broke something in the financial sector and the contagion will spread to other banks. Investors should keep an eye on headlines over the next few weeks to see if more financial institutions catch a cold. If more banks fail over the next few weeks, it could be a sign that the contagion is spreading.

The Fed has an FOMC meeting this week on Wednesday, March 22nd. Although there is a 74.5% chance of a 25 basis point increase to the Fed Funds rate, the market will be focused on Fed Chair Powell’s comments. The market wants to know if the Fed will become more dovish in its policy in light of the recent bank failures. Guidance that the Fed will become less hawkish could be bullish for the stock market. However, if the Fed sticks to its hawkish policy as planned to continue to battle inflation, the market could become discouraged. This could be one of the most important FOMC meetings of the year.

Intermarket Analysis: Interest rates fell hard as the market expects the Fed to cut interest rates to support the financial sector, which appears to need a lifeline. The 10-year Treasury rate fell 70 basis points from the recent high over the past two weeks. This could also be seen as a warning that the Fed pushed the economy into a recession, as interest rates typically fall quickly when the economy enters a recession. The US Dollar was largely flat, indicating that investors had not yet cashed out en masse.

Gold and treasury bonds (TLT), which are both inversely related to interest rates and seen as flight-to-safety assets, rose as rates fell.

Relative Strength/Weakness: Regional banks (KRE) were pummeled last week, declining 14%. Oil-related stocks were also weak, as the threat of a new financial crisis implies an economic slowdown, which will in turn reduce demand for oil and other commodities. The flight to safety trade from a sector rotation perspective was a flight to large technology companies and utilities, as XLK (tech), SMH (semiconductors), XLC (communications), and XLU (utilities) led the market. Apple, Microsoft, Google, Meta, Amazon, Advanced Micro Devices, and Nvidia had significant relative strength compared to the greater market. The configuration of this rotation is risk-on and suggests that investors are cutting exposure to financials, but adding exposure to offensive sectors. This implies that many investors are expecting a spring rally.

Oscillation Cycle: The S&P 500 appears to change trends every 40 trading days (larger cycle arcs below). The trends seem to sub-divide into two 20 trading day cycles (smaller cycle arcs below). We all know the market can do anything it wants, especially in a headline-driven market, but if history repeats itself and the market follows cycles of 40 trading days, then this current downtrend should end around 4/6. When the trend changes a couple of things should happen:

• Price should make its way above the 10-day moving average (black line overlay) and the 20-day moving average (blue line overlay),
• The CCI indicator should get above the 0 mark,
• The Trix indicator should cross and trend up,
• The McClellan Summation Index should start moving up.

With the exception of news supporting a full-on financial crisis, the S&P 500 should not have too much downside left. The Breadth oscillator ($NYAD below) is already close to the oversold level and the Bullish Percentage of S&P 500 stocks ($BPSPX) is starting to curl up. Price is also at the S1 support pivot point. If it falls further under normal trading dynamics, it could fall to the S2 pivot point at $386.02 or the S3 pivot point at $376.64. Again, if we have news of a financial crisis, the market could fall much more.

Sentiment: The sentiment picture is mixed. The Fear & Greed Model suggests that the downtrend has some more to go.

However, the Smart Money/Dumb Money Confidence indicator is showing that as dumb money is selling, smart money is buying heavily. This supports the idea that when the downtrend is over, we could have a strong spring rally.

Breadth & Volume: The breadth and volume picture for the market has deteriorated in light of the banking news. The New Highs/New Lows indicator shows a resurgence of stocks hitting new lows. The Advance/Decline Line breadth indicator shows a decline in breadth, albeit not so severe. The Advance/Decline Volume Line shows a steeper drop in volume. The fact that the Advance/Decline Volume Line fell quicker than the Advance/Decline Breadth Line displays that money is being reallocated to certain stock picks.

Volatility: The VIX is moving higher as the market loses its footing. The more interesting measure is the MOVE index (volatility measure of bonds), which is spiking. This is tied to the recent bank failures, where the bondholders and stockholders will probably suffer heavy losses as the government will not bail them out. This makes us wonder if there is a larger possible story. What other bonds will end up defaulting in the near future? Should the economy hit a hard landing and credit ratings fall, could downgraded debt-heavy companies refinance their debt? Could higher interest rates hurt their debt service abilities? The MOVE Index is a metric that should be watched carefully going forward.

Cycles & Seasonality: It’s interesting to see that the following cycle projection for KRE (regional bank ETF) was created in late January. The projection called for a decline starting around 2/18, and after the weekend, the decline started on 2/21. Should KRE continue to follow this cycle projection, there could be some relief around 4/5, followed by some more downside after 5/9.

The Cycle Composite and Seasonal Cycle for the S&P 500 points to a short-term top around 3/22 and a bottom around 4/6. This should be a good entry point for the spring rally, which could top out around 5/6.

Valuation: If a spring rally does occur, how far can it go? Unfortunately, the valuation picture is not conducive to a huge rally. The SPY is already at a P/E ratio of 18.06x. If it reaches the Normal P/E ratio of 19.65x that would equate to a target of $407. If a P/E ratio of 20 is reached, it would equate to a target of $427. Referring to the chart below, the SPY typically stays below the 19.65x P/E ratio line and was only able to blow past it during the post-Covid easy-money dovish Fed policy regime.

Conclusion: It’s a good idea to wait and see if the banking crisis is contained or if new banks will fall ill. Many signs are pointing to an upcoming spring rally, however, the rough macro environment and high valuation could limit the potential upside.