We shot right out of the gate in 2023 on hopes of peaking inflation, China reopening and defensive positioning at the beginning of the year. The market ended February by giving back some of those gains. We have grown more bearish as time has progressed and remain rather cautious until we get better confirmation of a new bull cycle starting. This has been prompted by technical indicators that point to lower market index levels as the Fed’s fight against “supercore inflation” has proved difficult. In this article we outline some of the technical and macro analysis that has us cautious.
SPX
The major US markets continue to trace the complex corrective pattern we outlined weeks ago in our premium service. What this pattern calls for is a final 5 wave drop to new lows. For SPX, the downward targets are 3295, 3150, 2940. If we get confirmation of this pattern playing out, we will look to remove our hedges and commence buying around these key price targets.
From an Elliott wave perspective, the structure of the bounce from the October 13th low warrants caution. Anytime we see a 3 wave bounce, the odds favor this pattern being a correction within the larger trend, which is down. The above chart is clearly 3 waves up.
This trend is supported by other important markets I’m following. Typically, for a major bull market reversal to occur these markets have to participate. Instead, they seem to be confirming the bearish setup.
Financials (XLF)
The Banks have been very strong since the October low. However, the structure of XLF off the low is also an overlapping 3 wave structure. Note how this 3 wave bounce has retraced the majority of the 2022 drop. Also, note the weakening momentum as price moves higher. This pattern may have one more high in it, but it is clearly a B wave/bear pennant until proven otherwise.
Transports
The Transportation sector is also flashing similar warnings.
Canada
The Canadian TSX is an important market to track for US equities. More times than not, it leads the US. When these markets diverge, it is a big warning of an imminent trend change. This is not what we are seeing. Note the bear pennant forming. This triangle pattern is common with B waves, which the TSX appears to be tracing.
Taking these markets into consideration and looking back at the S&P 500. If we zoom in on the bounce off the October lows, the S&P 500 appears to have an incomplete uptrend. The 3 wave bounce is marked by an A wave up, B wave down, and C wave up, which completes the 3 wave pattern. The C wave always plays out in a 5 wave pattern, and it appears that we only have 4 waves in place. This suggests that we will see a final run towards a double top, or 4225 SPX in the coming weeks, but this is not guaranteed.
The above blue count has been my base case scenario for several weeks. In fact, we removed some of our hedge and have gone net long (25%) in an attempt to capture some of this potential move. This move needs to manifest this week, or it is in danger of not playing out.
If it does not, I will have to consider the red count as the new base case scenario. In this scenario, SPX already topped and is almost done with the 1st wave down in the final move towards the 3000 SPX level. If we push towards 3905 before breaking out over 4040, then this will become the base case scenario and will we look to fully hedge on the 2nd wave retrace. In both cases, we should see a larger bounce before the wheels fall off.
What are the Commodity futures telling us?
As technology investors, the Fed’s actions have raised the cost of capital for firms and impacted the valuation for technology companies. Hence, I believe it’s important to monitor those markets that are shaping the Fed’s inflation outlook for clues so that we can properly position. The most important to monitor is food and energy, both of which are suggesting higher prices into the near future.
Wheat
Wheat prices look to be completing the 5th wave in this large correction. It is trending down into major support with a cluster of cycles coming into play between Feb 28-Mar 3. Once we see a bottom, a large degree bounce should follow. This means food prices are likely going up.
Energy
Gasoline looks very similar to oil prices below. This very much looks like a consolidation before the next move higher. The next major cycle is in late April (this is a very big time frame to monitor). I doubt that we consolidate above the 1×2 line for that long. Look for energy prices to move higher in 2023, which will only put pressure on inflation.
Macro Analysis
Recent data growth has opened the door to the prospect of a “soft landing” or “no landing.” We discussed what a soft landing looks like last week – manufacturing contracts while services does not contract too much more. This last happened in 2014-2016, and most famously in the mid-90s. The idea of no landing means that we just continue to expand from here, avoiding a recession all together.
We would be onboard with this rosy outlook if it wasn’t for one key data point – inflation. All prior soft landings going back to the 80s had one factor in common – a supportive liquidity cycle. With inflation under control, the FED was able to allow the continuation of a supportive liquidity cycle (2014-2016), or start up a new liquidity (mid-1990s).
With talking heads focusing on stronger than expected growth metrics in the economy, they fail to acknowledge what this means for inflation. In short, inflation may have peaked, but the real battle will be getting it from 6.4% to 2%.
If you pay attention to what the FED is saying, they are now tracking something they are calling “Super Core” Inflation. This metric excludes food and energy, like regular core inflation, but goes one step further to exclude all other goods as well as shelter. Because the US GDP is ~85% tied to services, this gives the FED a look into how their policies are affecting the largest segment of the US economy.
In January, the Super Core prices rose at a 7.4% annualized rate. This is the fastest increase for any month since 2021. These prices are up 4.6%, which is just off its peak at 5%.
It is alarming how little effect the current aggressive rate campaign by the FED is having on services. While manufacturing remains in an on-going contraction, services continues to expand, proving that the economy is much more resilient than expected. This also means the FED will likely have to hike higher and for longer than the equity markets are pricing in.
So, the only questions an investor needs to ask – is it more likely or less likely that the FED will start up a new liquidity cycle soon, based on the overly resilient services segment of the economy? Will starting a new liquidity cycle hurt or help their primary goal to get inflation back to 2%?
Where could I be wrong?
Dow Jones Industrial Index (DJI)
The consolidation pattern in DJI broke to the downside, as it suggests a continuation of selling before a low takes hold. I’ve stated before, and will repeat, as long as the DJI holds its October low, no matter what else happens, it will set up a great buying opportunity. This still holds. However, for me to reverse course, the Dow needs to reclaim its December high.
Financials (XLF)
I’m adding XLF to the mix. Like the Dow, it needs to reclaim its February high.
Bonds
I’ll also want to see TLT take out its December high.
It point out these markets because if we are entering a new bull market, all of these markets will confirm it in unison.
Conclusion
Given the macro backdrop, Winners and Losers will emerge within the technology sector. From a fundamental stock perspective, the team has been focusing on companies exposed to secular rather cyclical growth with strong competitive moats. However, given the warnings and uncertainty within the macro backdrop, we prefer to be cautious right now, as we believe that the market will provide us with better entry points. Regarding our 3 stock portfolio of NVDA, AMD, NFLX, we will go into detail about these positions next week.