Weak Fundamentals Cancel the Spring Rally

Fundamentals are king, and this year weak fundamentals appear to be cancelling the seasonal spring rally. Statistically, the Dow Jones Industrial average has been up in April for 16 years in a row. The S&P 500 has been up for 15 out of the last 16 Aprils (Source: Stock Trader’s Almanac). This year spiking inflation, a war in Ukraine that could expand, rising interest rates and a tightening Fed that plans to reduce their balance sheet in May were too many negative factors for the stock market to stage a normal seasonal spring rally. Additionally, the stock market is still overvalued with a Forward P/E of 18.85x. A more reasonable Forward P/E of 16x would produce a target price of $3,728, which is 15% lower than Thursday’s close price of $4,392 and 23% down from the high. I believe that Wall Street is front-running both the Fed tightening in May and the upcoming recession, and this explains the absence of the spring rally this year (see chart below).

Source: Stock Trader’s Almanac

Technical Analysis - Going into April it seemed like technicals, seasonality and cycles were supporting a possible spring rally (see chart below and note that data is as of April 14th). As of April 1st, the price of the S&P 500 was above the 20, 50 and 200 day moving averages, which signal an uptrend. By April 11th price broke down below all moving averages and the decline was on increasing volume. Increasing volume indicates that institutions took the elevated prices from the mini-uptrend (March 15 to March 29) as an opportunity to reduce their equity positions at a relatively high level. Technical indicators say that there could be more downside. The RSI is at 44.53 and the will market will not be oversold until the RSI hits 30, so the market could move down more from here. The MACD had a negative cross, indicating that downside momentum is increasing. Breadth never supported the last uptrend as the NYSE New Highs vs. New Lows never could really get out of the red. Meanwhile the 10 year treasury rate is increasing rapidly. The 10-year treasury rate acts as a discount rate to stocks, so as the rate increases, stock valuations (PE ratios) will face a downwards pressure.

Market Oscillations - I’ve noticed over the years that the market seems to oscillate from bullish to bearish and back again in a never-ending cycle. Below is the chart setup I use to best understand where we are in the oscillation. The McClellan Oscillator (NYMO) and 10 day moving average of the NYSE Advance/Decline Line (NYAD) tell me the trend of individual stocks. These moves are usually supported by a VIX going in the opposite direction. For example, a low NYMO and NYAD which starts moving higher as the VIX falls is a sign that a bullish oscillation may be beginning. Note that no trading system is always correct and even this is subject to possible whipsaws or false signals. When a rising NYMO and NYAD is paired with a declining VIX and is accompanied by an oversold RSI and Stochastics reading…if price can break above a rising 8 day exponential moving average a bullish oscillation setup is complete. This may be the start of a new uptrend swing. The opposite is true for a bearish oscillation setup, which could lead to a new downtrend swing.

The blue bands around price are called Bollinger Bands. The bands are set at 2 standard deviations from the 20 day moving average (roughly 1 month of price action). I notice that price often moves from one bollinger band to the opposite bollinger band (low band to high band and vice versa) or from one bollinger band to the midpoint before continuing trend.

So where are we now in the oscillation? We have a declining NYMO and NYAD which are both not at bearish extremes yet (the lower blue line). The VIX is moving higher. The RSI is at 44 and can move down to the 30 level which is where it starts to become oversold. The stochastics is already in the oversold are, however this indicator could have multiple bottoms before it starts to move up. Price is below the 8 day exponential moving average. As such, the S&P 500 is in a downtrend that is not oversold yet, so more downside is possible. We are at the lower bollinger band so it is still possible that the market picks up here. This however will take a significant show of strength.

Wyckoff Market Cycle - A large concern I have is that I suspect the market is in a Distribution Phase of the Wyckoff Market Cycle. This cycle states that the market goes from an Accumulation Phase to a Markup Phase, to a Distribution Phase and finally to a Markdown Phase. I believe the cycle works like this:

• Accumulation Phase occurs after a Markdown Phase and equities are attractive to institutional investors because they just got beat up and are at low valuations
• Liquidity Cycle - The Fed steps in to support the market by lowering interest rates and using their balance sheet add liquidity to the system
• Business Cycle - The economy is in full recession and needs a handout from the Fed to spur growth
• Earnings Cycle - Earnings are declining
• Market Behavior - Investors take their pick from many attractive stocks with attractive valuations. Volume buy spikes are evident. Support levels hold.
• Markup Phase occurs after an Accumulation Phase where investors make money
• Liquidity Cycle - The Fed is continuing to pump liquidity into the system, but begin worrying about inflation
• Business Cycle - The economy is out of recession and into growth and recovery
• Earnings Cycle - Earnings are starting from a low point, have “easy comparisons” to previous years earnings and are growing — stocks pop on earnings
• Market Behavior - High flying growth stocks make many people money and everyone feels like a stock market genius. Moving averages are sloping up
• Distribution Phase occurs after the Markup Phase and institutions take profits while valuations are high and the economy is peaking and moving towards recession
• Liquidity Cycle - The Fed fights inflation and begins a contractionary policy (increase interest rates and reduce balance sheet)
• Business Cycle - Employment is strong but inflation is high during a late economic recovery or peak
• Earnings Cycle - Earnings are still strong but starting to weaken as revenue and earnings growth start to decelerate and start to contract, stocks dump on earnings
• Market Behavior - Volume sell spikes are evident and support levels crack. Moving averages flatten out as price declines below them.
• Markdown Phase occurs after the Distribution Phase and the stock market falls hard
• Liquidity Cycle - The Fed knows they failed to engineer a “soft landing” and created an economic recession, and begin to consider supporting the market again
• Business Cycle - Unemployment increases and the economy is in a recession, driven by declining liquidity
• Earnings Cycle - Earnings drop hard and some companies report losses
• Market Behavior - Prices fall fast on high volume and moving averages are downwards sloping

The 30 week (or 150 day) moving average is quite good at working with the Wyckoff Market Cycle. The chart below displays how it is flattening out as price drops below it:

This looks similar to how it looked in late 2007 before the 2008 bear market:

It also looks similar to late 2000 as the 30 week moving average flattens out and price declines below it:

Another large concern on my mind is that the 10 year vs. 2 year treasury yield curve inverted at the end of last month and started to re-steepen. Historically the yield curve inversion is a forward warning of a recession, but a significant stock market drop occurs when the yield curve re-steepens, which often comes months later. It’s re-steepening now. This hints to me that a recession will come sooner rather than later. Disappointing bank earnings from JPMorgan, Goldman Sachs, Morgan Stanley and Wells Fargo that reported this past week may indicate the start of a trend of corporate revenue and earnings contractions.

Relative Strength - I believe that hedge funds and institutions are front-running the recession through their sector rotation, as they are bidding up Utilities, Consumer Staples and Healthcare stocks, which are considered defensive sectors. In the business cycle when defensive sectors outperform, it implies that the economy is moving towards an early recession (see chart below).

Over the past 14 trading days I’ve noticed that defensive sectors — energy, utilities, consumer staples and healthcare —have been leading the market. This flight to safety tells me that institutions are positioning their portfolios for a coming recession.

The sector charts speak for themselves. The charts below for Utilities (XLU), Consumer Staples (XLP) and Healthcare (XLV) have relative strength compared to the S&P 500. Note that the indicator under the chart is a price relative to the S&P 500 indicator, thus a black line sloping up means that the etf is outperforming the S&P 500. It seems like institutions are preparing for something.

Cycles - I wanted to look at a new cycle this week. Equityclock.com provides cycle forecasts for the 4 year Presidential Cycle, the 7 Year Cycle and the 10 Year Cycle. I wondered how these cycles would look on a combined basis and I was able to combine these cycles using Timing Solutions software (see below). This cycle projection uses data from the Dow Jones Industrial Average going all the way back to 1885. This looks quite bearish with a double bottom that could happen this year, where one bottom could occur in late June and another bottom could occur in early October.

Bullish Thesis - Is there a bullish thesis? Yes there is a short term one and a longer term one.

• Short Term Bullish Thesis - The mid to late March uptrend is now at about a 50% fibonacci retracement. This means that price retraced 50% of the up leg. Based on the fibonacci retracement technique, an uptrend is still possible as long as the uptrend does not retrace more than 61.8%. We are not there yet. A spring rally could still happen, but taking a holistic point of view, I give the bullish thesis a small probability of occurring.

• Longer Term Bullish Thesis - There is sometimes a “blowoff top” before a bear market. This means that the market hits new highs and has very bullish sentiment before a major downturn begins. We just had a blowoff top in 2020, where the drop occurred when there was high bullish sentiment. Notice the NAAIM (Active Money Manager Equity Exposure) was about 100% two months before the drop. The Bulls vs. Bears ratio was also largely bullish. Blowoff tops often occur after a yield curve inversion, which fits the current time period as we just had a yield curve inversion. For this scenario to take place, the S&P 500 has to first get back above the 20, 50, 150 and 200 day moving averages, which is not the case at the moment. If price could get above the moving averages, I could consider a possible blowoff top.

Conclusion - Taking all of these factors into account, I believe it is time to go back into Protection Mode or Risk Management Mode. This is due to the growing evidence that a bear market and recession is on the way. The evidence presents itself in both price action and fundamental indicators. Protect your hard-earned capital and remember two bits of wisdom:

1) There is nothing new under the sun - Cycles repeat themselves and although they are not identical, they tend to rhyme

2) This too shall pass - After a Distribution Phase and Markdown Phase where it’s tough to be an investor, new opportunities will show up in the next Accumulation Phase.

Friends, I hope everyone is able to navigate through these times successfully. Have a wonderful week.