Updated October 2, 2023
Raymond Micaletti, Ph.D.
The equity market closed the third quarter on a mixed note. The S&P 500 lost a bit more than half a percent while the Nasdaq 100 and Russell 2000 eked out small gains.
The dollar continued its inexorable rise, as did long-end interest rates. despite several economic reports coming in on the weaker side (e.g., housing, core PCE).
Oil was mostly flat, while gold (-4%) and silver (-5.7%) suffered sharp losses (it appears they finally woke up to the reality of real interest rates).
This week will bring lots of labor market data along with a bevy of Fed speakers.
No major shifts occurred in investor positioning last week, but institutional behavior in equities was quite atypical:
Equities: Composite equity relative sentiment rose from 35% to 47%, a neutral reading. It looks set to hover within the 40%-60% range for the foreseeable future.
Notably, however, institutions sold a significant amount of equities from the day of the FOMC meeting up until last Tuesday. Equities were falling materially during that time. Typically, institutions buy when the market falls and sell when it rises. The fact they were selling as the market fell is reminiscent of when they were buying the Nasdaq 100 in January when it had risen 12% that month. If the corollary holds, equities might face choppy seas ahead.
Dollar: Dollar relative sentiment flipped bullish last week after 11 months of being bearish. It will remain bullish this week and for the foreseeable future.
Gold: Gold relative sentiment remains bearish. (Gold suffered sharp losses late in the week and it will be interesting to see if institutions covered their shorts as gold fell.)
The Bull Case
Momentum: We are still downwind from several momentum triggers and breadth thrusts from earlier in the year—the windows over which they tend to act would take us into Q1/Q2 2024.
Year-end seasonality: Year-end seasonality is typically favorable, but even more so when the market is up substantially going into Q4.
Gaps above: The selloff from the highs has left a few unfilled gaps above the current market level. As gaps tend to get filled, we should expect the market to eventually fill them. Whether that happens sooner rather than later is an open question.
Oversold bounce? Equities stopped going down last week at the 61.8% Fibonacci retracement from the all-time high to the October 2022 low. This also happened to coincide with the uptrend line from the October low. Equities are oversold on several metrics (though not on our preferred ones) and, as a result, we may see a short-term bounce to clear those oversold conditions.
Dollar, rates, oil due for a pullback? Given the intensity of their ascent (dollar up 11 weeks in a row, oil up 27% in Q3, etc.), one could argue it's time for a pullback in the dollar, rates, and oil. If so, equities would likely respond favorably. (Note, however, that the dollar, rates, and oil all have substantive reasons to continue higher with or without a pullback.)
The Bear Case
Valuations: 10-year expected annualized (nominal) U.S. equity returns ended the week at 2.8%, while the 10-year U.S. Treasury yield closed at 4.57%. Thus, holding 10-year Treasuries over the next decade is likely to produce higher returns than holding U.S. equities (but 10-year Treasuries are likely to underperform inflation).
Fiscal dominance: Treasury rollover plus new issuance plus quantitative tightening plus sovereigns selling Treasuries to raise dollars to buy oil is straining the balance sheet capacity of the market. Yields (and particularly real yields) have risen accordingly, equities have taken notice.
Equity positioning: While overall equity relative sentiment is a neutral-ish 47%, certain relative sentiment indicators, such as our flagship positions-based metric, are aggressively bearish. Moreover, institutions just completed another week of strong selling during a period when the market was falling. As institutions tend to buy low and sell high, the fact they were selling into a downdraft should be concerning for equity bulls.
Reemergence of inflation? Oil finished the quarter up 27% and its supply deficit is set to widen to 1.2 million barrels per day by the end of the year.
Credit spreads widening: High-yield credit spreads have moved above their 20-day moving average, a threshold that tends to correspond with risk-off periods in the market.
Dollar relative sentiment: Dollar relative sentiment has turned bullish. The last time it turned positive, in August 2021, it ushered in a 13-month, 18% rally in the dollar. Continued dollar strength would likely be accompanied by higher long-end rates, which would further pressure equities.
Large inflows into TLT: Typically, when an asset loses 50% of its value, investors run away from it. That isn't the case with TLT, the 20+ year U.S. Treasury ETF, which saw $16 billion in inflows last week. This strikes us as a bearish indicator for TLT, which, if so, would suggest higher rates and continued downward pressure on equities.
Everyone expects a Q4 rally: At the end of Q3 last year virtually no one was expecting a Q4 rally. Equities were in the midst of a steep nosedive and bulls were sheltering under their desks (speaking from experience). Now, everyone is expecting a rally, but positioning is not nearly as bullish now as it was last September/October.
We have had a cautionary outlook the last few weeks as equity relative sentiment took on its lowest values in over a year. Today our caution remains—we don't think the coast is entirely clear for equities just yet—but a short-term bounce could be on tap.
The market had opportunities to go much lower last week, but stubbornly held at the confluence of the 61.8% Fibonacci retracement (from the all-time high to the October 2022 low) and the uptrend line from the October 2022 low. That confluence of levels would appear a natural place for the market to attempt a bounce.
Additionally, long-term interest rate charts have gaps lower and equity charts have gaps higher. Both could fill in one fell swoop on a multi-day equity rally (from oversold conditions).
That said, neutral overall equity relative sentiment, the uniform bearishness of our flagship positions-based relative sentiment indicator, strong equity selling by institutions into a falling market, broad consensus for a Q4 rally, and the massive inflows into TLT suggest sentiment isn't bearish enough yet to propel us meaningfully higher.
Thus, we may see another flush lower to create more favorable sentiment conditions for a stronger bounce later in Q4.
If instead equities were to continue higher with no further pullback, we would expect institutions to continue selling into the rise and for that rise to be our final ascent into a major top that could last for an extended period of time.
The near- and intermediate-term paths for equities likely hinge on the path for oil, rates, and the dollar. All have had strong rallies. All seem overdue for a pullback. But all have ample reasons to continue higher with or without a pullback.
Thus, the dollar and oil may not have topped and bonds may not have bottomed. Consequently, it's hard to argue for an aggressive position in equities at the moment. Hence, our continued cautionary stance.
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