Proceed with Caution, but do Proceed

Igor Manukhov - Feb 21, 2023

Enthusiasm seem to be waning, proceed with caution. Silver lining is that buyers seem to be showing up during market weakness.

Market participants showed their cards this week. Looks like a lot of people bet a lot of money on FED slowing down their rate hiking campaign. So, as soon as there was a hint of another 0.5% rate hike, markets went down. I looked under the hood of the recent market price action and I noticed that the market is taking a breather. Unfortunately, it is not a black and white situation. I will outline the positives and negatives I see on this chart. 

 

Positives:

  1. Price finally broke through a downward trend and is trying to rally (the black line is trading above the green line of 150-day moving average).
  2. Selloffs have been more shallow than before. This is a sign that buyers might be coming back to get bargains.
  3. High Yield bond spreads (premium banks charge bad borrowers for credit compared to what good borrowers pay) have been going steadily down (look at the orange line on the bottom of this chart).

 

Negatives:

  1. Rally lost steam right around resistance area of 4100-4200. Buyers seem to not be ready to pay more at the moment.
  2. Recent price advance was carried by fewer stocks than the previous rally (market breadth divergence). Notice how price surpassed previous high point in November but Bullish Percent Index (purple line that measures how many stocks participate in the rally as a percentage (from 0% to 100%)) failed to surpass previous high. I outlined that divergence with red lines
  3. Recent price advance was not supported by momentum (MACD indicator). Again, we can clearly see divergence (i.e., the price surpassed previous high but momentum did not, as marked by red lines). 

 

In previous instances, these divergences signalled a change in market direction (blue lines). 

 

The weight of evidence suggests that we should proceed with caution. On one hand, historically these divergences have been pretty accurate in signalling a change in direction (in this case for the market to go down), on the other hand, a break of a very important downtrend line as well as the lack of worry from high yield bond market give me hope that this is just a minor pullback. If it even materializes, I do not expect it to go lower than 3900 - 3950. Barring any major bad news from FED, I would use this dip as a buying opportunity. Just in time for RSP contribution, I suppose.