Did Something Just Break?

 

In last week’s missive I stated:

“There has been a pretty well defined upward trendline (gold box) since the April lows which has consistently provided better entry opportunities to increase equity exposure.”

“As stated, our existing portfolios are currently fully weighted toward equity risk as there seems to be little which can derail this market currently. We have moved stop-loss levels up to recent lows, added some defensive positioning, and have added bonds as rates have climbed above 3%.

Speaking of rates, each time rates have climbed towards 3%, the market has stumbled.”

Chart updated through Friday close.

I got lots of emails early last week suggesting “this time was different.” Rates were rising because of strong economic growth and as such, it wouldn’t affect the stock market. (More on this in a moment.)

If you note in the chart above, a short-term “warning signal” has been triggered which suggests that if rates remain above 3%, stocks are going to continue to struggle. The last time this occurred was in May when rates popped above 3%, stocks struggled and bonds outperformed.

Over the last couple of weeks, I have noted that after increasing equity exposure in portfolios, the short-term overbought condition needed to be resolved before the markets could make a year-end push higher to 3000.

Not surprisingly, the statement triggered a lot of questions as to why, at a time when the market was at 2950, I was only giving the markets 50-points of upside? The reason was that a pullback was needed to open up the potential for a year-end push. On Thursday and Friday, as the markets woke up to the recent surge in rates above 3%, markets sold off back to support at the January breakout highs. That sell-off does provide enough of an oversold condition to support a year-end push which has now expanded from just 1.6% last week, to 3.33% over the next couple of months.

I also noted last week, that we would be updating our pathway chart, as first shown above, which has remained unchanged for well over a month (prices have been updated through Friday’s close.) What was most surprising to me was how closely the markets had traced out the projected #2a pathway.

With this background, we can update the pathways which hold the highest probable outcomes over the next couple of months.

There has been a pretty well defined upward trendline (gold box) since the April lows which has consistently provided better entry opportunities to increase equity exposure. While there are literally thousands of potential outcomes over the next couple of months, I have refined what I think are the most likely outcomes down to four possibilities.

Pathway #1:  The market sold off to the peak of the January highs which is support. With the market now short-term oversold a rally to new highs through the end of the year is possible (20%)

Pathway #2a: The first of two most probable outcomes at this juncture is a rally from the current support at the January highs but the rally fails at 2900 which forms the right should of a “head and shoulder” topping pattern from the August left shoulder peak. The bullish outcome is a selloff back to the January highs and the market then rallies to new highs by year end. (40%)  

The bearish outcome, is a violation of the “neckline” at the January highs and the market continues to track Pathway #2b

Pathway #2b: Rising interest rates continue to weigh on stocks next week and the market breaks the January high support level. However, given the short-term oversold condition, the market rallies from the bottom of the current bullish trend (gold box) but fails to rise above the January highs and turns lower putting in a more major top for the year. (30%)

Pathway #3: The issue of rising interest combines with a break in the economic data, or another credit-related event, and sends the market heading back to test supports at 2800 and 2750. This would likely coincide with a more severe contraction in the economic data which is not an immediate threat. Nonetheless, we should always consider the risk of an unexpected, exogenous, event. (10%)

Next week, I would expect to see a rally from the short-term oversold conditions. However, it will be the breadth and strength of that rally that will be important to watch.

If it is a weak, narrow bounce with little conviction, we will use the rally to lift positions, trim losers, raise cash and potentially look at initiating some hedges.

Our bigger concern remains interest rates simply for one reason – you can NOT have higher stock prices AND higher interest rates. Period.

One or the other will have to give.

Did Something Just Break?

Over the last few days, the internet has been abuzz with commentary about the spike in interest rates. Of course, the belief was that rising rates were “okay” because the market was still rising. As noted on Wednesday by Charlie McElligott (via Zerohedge):

“Effectively the market is saying that in the absence of an ‘inflation shock’ (which would drive a front-end yield spike / ‘power flattening’ on ‘accelerated Fed),’ that we are on track to ‘grow faster than we are tightening’

Another way of putting it is that Wednesday’s ‘economic assessment upgrade’ and view that we are ‘growing faster than we are tightening’ is why we are not seeing that same ‘rate – and VaR shock’ contagion into risk-assets that defined the market in late January, early February, and which – as McElligott notes – ‘was BY-FAR the #1 client inquiry, i.e. ‘Why are higher yields not negatively impacting Stocks here?.’”

On Thursday and Friday, stocks crumbled as the reality that higher rates and tighter financial conditions will begin to negatively impact growth data. With housing and auto sales already a casualty of higher rates, it won’t be long before it filters through the rest of the economy.

The chart below shows nominal GDP versus the 24-month rate of change (ROC) of the 10-year Treasury yield. Not surprisingly, since 1959, every single spike in rates killed the economic growth narrative.

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Disclosure: The information contained in this article should not be construed as financial or investment advice on any subject matter. Real Investment Advice is expressly disclaims all liability in ...

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