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Updated February 14, 2023

A Natural Pullback or the End of the Rally?

A Natural Pullback or the End of the Rally?

A Natural Pullback or the End of the Rally?

Raymond Micaletti, Ph.D.

Raymond Micaletti, Ph.D.


The broad U.S. equity market took a much needed breather last week, falling 1.3% after having risen 8% to start the year.

Although the market’s overall retreat was modest, from its Tuesday high to Friday low, it fell 3%, which sparked concerns the multi-month rally we have witnessed might be ending.

While it’s certainly possible the rally may be on its last legs given:

  • Renewed fears inflation may reignite on account of the continued strong labor market and still-firm commodity prices

  • The (bearish) shift in how high the market perceives the Federal Reserve will raise interest rates and how long the market thinks the Fed will keep them there

  • The bounce in the dollar appears to be tracing out a “bull flag” pattern, which suggests the dollar may have yet another leg up

  • Retail sentiment, while far extremes, has become more bullish than at any time since late 2021

  • Interest rates have risen strongly from their early February lows

  • The volatility of volatility, which some say has a “sixth sense” about market direction, has begun to increase—suggesting the market may be ripe for more downside

Nonetheless, we believe the rally is not over.

As we mentioned last week, the market simply could not sustain its recent torrid pace and we should expect that pace to weaken (by the market either moving sideways or retracing some of its gains).

In the near term, the market may continue to pullback—indeed, this week we will get economic reports on inflation and retail sales, which will likely lead to even more volatility. Such a pullback would, in true market fashion, punish those late to the party.

Moreover, from a technical perspective, the market still has some room to fall without violating the uptrend line from the October lows. 

But until institutions definitively position for lower equity prices, in our opinion, the odds still appear to favor the upside.

The tricky thing is that the Commodity Futures Trading Commission (CFTC), which publishes the Commitments of Traders (COT) Report—the report that tells us how different classes of investors are positioned—has not published the report in two weeks due to a “cyber incident” at one of the third-party vendors involved in the aggregation of the positioning data.

Thus, it’s possible that in the last two weeks institutions have unloaded their long positions and have begun positioning for a resumption of the downtrend.

Given the last COT readings before the interruption, however, it doesn’t seem likely that institutional positioning could have flipped from bullish to bearish that quickly given the strength of their bullishness at the end of January.

Moreover, other measures of relative sentiment between institutions and retail investors continue to be strongly bullish.

Thus, we think this recent pullback is a natural, healthy pullback in what appears to be the beginning stages of a 6-12 month cyclical rally.

But we won’t know with certainty whether institutions are still positioned for more upside until the next COT report is published (hopefully this week—get your act together CFTC!).

That all said, investor positioning in assets related to non-U.S. stocks, small cap stocks, and energy stocks may have shifted to a stance that, while not overtly bearish, is not overtly favorable for those areas of the market either—based on where those readings were in late January.

Thus, if the market does ultimately continue higher, it may continue to be led by the U.S. and, in particular, the tech and consumer discretionary sectors.

One idea that has been gaining steam on Twitter is the notion of a “#bigflip.” I.e., the notion that the dollar will resume its uptrend and stocks (and bonds) will resume their downtrend. 

While we have little doubt that such a transition will happen eventually, we don’t think that time is now, primarily because the financial media has once again turned significantly bearish.

JPMorgan, Morgan Stanley, Bank of America, Goldman Sachs, Blackrock, Mohamed El-Erian (one of the world’s foremost public intellectuals), and many others have expressed qualms about this rally or have outright said not to buy stocks.

Typically, markets top when everyone is bullish and can’t conceive of bad times ahead. That’s when institutions sell and leave retail investors holding the bag.

But today, the market establishment is expressing skepticism and retail investors will react to that skepticism by staying out of the market or by selling. Thus, in our opinion, it’s likely markets have to move higher—climb a “wall of worry” as the saying goes—to remove that retail skepticism. Only then do we think markets will top.

Again, don’t expect a rocket-launch higher, and be prepared for potential additional downside in equity markets. But until positioning changes materially, the uptrend is likely to persist. Our forecasts remain unchanged.


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