This Indicator May Have Just Signaled the Next Bull Market

The S&P 500 (SPX) and Nasdaq Composite (COMPQ) were both down last week, which was not overly surprising given that the Nasdaq logged five consecutive weeks of gains heading into the week. Despite this correction, both indexes remain solidly in positive territory for the year, with the S&P 500 up 7% and the Nasdaq Composite up 12%, respectively. The powerful performance is attributed to what looks to be a less aggressive stance on rate hikes than some expected and the fact that both indexes came into the year heavily oversold and likely to bounce on any positive news. That said, this recent strength has not yet translated to an improvement in the bigger picture, as both indexes remain below their 20-month moving averages.

(Source: TC2000.com)

As for news-flow, last week was a relatively quiet week, with earnings season continuing to be mostly positive, except for Lyft (LYFT). PepsiCo (PEP) reported strong earnings and a major beat vs. estimates, Disney (DIS) beat analyst estimates, and Yum Brands (YUM) also had a very solid quarter on the back of strengthening sales at Taco Bell. We will get a better idea of the health of the American consumer this week when Restaurant Brands International (QSR), Krispy Kreme (DNUT), and Chef’s Warehouse (CHEF) report, but overall sales have exceeded my expectations for quick-service restaurants, and Chef’s Warehouse should give a better look at how casual dining and independent restaurants are faring with it being a leading food products supplier.

Regarding the bigger picture, although the Federal Reserve appears to have gone from full throttle hikes to riding the brake and digesting the data based on recent commentary, key data this week such as the January inflation numbers could force them to reverse their course. This is because while Federal Reserve chair Jerome Powell is confident that he is beating inflation, a higher than expected reading could force him to take a more aggressive stance, especially with some speculative activity returning to the market.

A shift in course from semi-dovish to short-term hawkish would not be ideal for the overall market or the economy, with consumers in a weak position already and seeing little relief anywhere, with tightened financial conditions and higher rates not helping this setup. Hence, a 6.5% plus reading could spook the market.

Sentiment

As discussed in previous updates, although the fundamentals are important, there comes a point when fundamentals may be priced into the market. For this reason, watching how sentiment indicators and valuation trends are quite important given that they can provide a better idea of when it’s smart to ignore the fundamentals or discount them given that they’re reflected in the market.

As I noted in early January, we were seeing elevated levels of fear with the market sitting just above key support at 3500 on the S&P 500, suggesting that while the fundamentals were ugly, there was reason to be optimistic about higher prices. However, as shown in the below charts, sentiment is now swinging towards more complacent.

(Source: NAAIM Exposure)

(Source: CBOE Data, Author’s Chart)

Looking at NAAIM Exposure readings above which measures active manager exposure based on managers surveyed, long exposure to the market has increased from 35% in December to 85% last week, a significant increase with active managers clearly more bullish. Meanwhile, the equity/put call ratio has seen readings dive from 0.90 or higher to sub 0.65, suggesting short-term complacency vs. elevated fear for most of November and all of December.

This doesn’t mean that the market has to head lower, but a pullback to cool off sentiment would not be surprising at this point. That said, and as I’ve discussed in previous updates, the breadth thrust signal generated on January 12th suggests that pullbacks are likely to be more mild, with stats shown below for the past 27 signals on a forward return and drawdown standpoint.

Obviously, this 28th signal for this indicator could be the time that it fails, and anything is possible. However, given the track record of this signal with no undercuts of major lows over the next six months and strong upside follow-through, the odds have significantly increased that we will transition from a cyclical bear market into a new cyclical bull market, with odds strongly in favor of the bulls over the next 6-12 months, potentially setting up a steady uptrend back to the 4400-4600 level even if this signal were to underperform the average. 

So, what’s the best course of action?

Heading into the week, the S&P 500 remains in the upper portion of its strong support/resistance range (3500 vs. 4315) and also in the upper portion of its range even using short-term support at 3765 – 4315. This results in a less favorable reward/risk for the market short term. Based on this, I’m not in a rush to add new exposure here to the S&P 500 or Nasdaq. In fact,  I would not be surprised if we see further downside over the next few weeks to cool off sentiment readings. In terms of areas of interest, a pullback below 3850 would offer a much better reward/risk setup for adding exposure to the overall market.