China, Yields, And The Coming Deflationary Impulse

Finally, after a week of false starts, the “buy signals” kicked in, and the markets mustered a rally. As we stated last week:

With markets deeply oversold on a short-term basis and with signals at levels that generally precede short-term rallies, the rally on Thursday and Friday was not unexpected. Notably, the S&P 500 held support at the 50-dma and rallied back into the previous trading range. 

On Wednesday, the Nasdaq triggered its short-term “buy signal,” which will likely provide some relative outperformance over the S&P 500. It will be important for the Nasdaq to hold above the 50-dma into next week

The good news is that we did indeed get the rally we were expecting. The not-so-good news is that the rally already consumed a majority of the “buy signal.” Such does not mean the market is about to correct; it does suggest that upside remains limited near term.

However, the S&P 500 buy signal has a bit more room to run. Such suggests we may see some relative performance pickup between the S&P 500 and the Nasdaq over the next week or so.

Our more significant concern remains the weekly sell signal. Historically, these weekly signals typically denote periods of more significant volatility swings or corrections. The biggest correction risk comes when the daily and weekly signals align.

Importantly, these weekly sell signals do not always resolve into a correction. However, by the time you realize a correction has started, it is often too late to do much about it. Therefore, we tend to take these weekly signals at face value and adjust our risk exposures accordingly.

Still Expecting A Bigger Correction

As discussed over the last few weeks, we still expect a more extensive correction this summer. Currently, the markets are in an exceptionally long stretch in the market without a 5% pullback, so the odds are rising.

Importantly, as noted in this week’s “3-Minutes” video below, the one thing we continue to watch very closely is interest rates.

Wall Street analysts continue to ratchet up earnings at one of the fastest paces on record. For earnings to meet these rather lofty expectations, economic growth must sustain a very high growth rate into 2022. However, interest rates peaked a couple of months ago suggesting economic growth will weaken in the months ahead.

If rates are sniffing out slower economic growth as stimulus fades from the system, the earnings are at risk of fairly significant downward revisions. In the market figures this out, a repricing of assets is likely.

Such is why we continue to suspect a 5-10% correction is a higher probability than most think.

Inflation Is Likely Transient

We previously discussed that inflation might indeed be more transitory given the impacts creating increased prices were artificial. (i.e., stimulus, semi-conductor shortages, and pandemic-related shutdowns.) To wit:

“Inflation is and remains an always ‘transient’ factor in the economy. As shown, there is a high correlation between economic growth and inflation. As such, given the economy will quickly return to sub-2% growth over the next 24-months, inflation pressures will also subside.” 

 

“Significantly, given the economy is roughly comprised of 70% consumption, sharp spikes in inflation slows consumption (higher prices lead to less quantity), thereby slowing economic growth. Such is particularly when inflation impacts things the bottom 80% of the population, which live paycheck-to-paycheck primarily, consume the most.”

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