It’s A Hard-Penny Stock Market

Stocks have rallied into resistance.
Uncertainty has caused stocks to churn sideways since mid-November.
A wait-and-see approach until a trend establishes itself may be wise.

Sitting on the sidelines is hard because the pressure to make money is high, especially if trading is the main source of household income. In a raging bear market, patience pays less. However, it can pay handsomely in bear markets when uncertainty makes gauging risk to reward tough.

The stock market’s made a big move since mid-October, but major market indexes now sit at a crossroads. Support from short covering, which fueled the first half of the move higher, has waned, and institutional managers and intermediate-term investors are reticent to press the buy button, given the S&P 500 is bumping its head on critical 200-day moving average resistance, inflation remains high, and economic uncertainty has increased.

In short, we’re at a point when bear markets rallies typically fail, making this a tough-penny environment for stock pickers.

The stock market has made little progress since mid-November

The S&P 500 ETF (SPY) is up 11% this quarter, but as of early today, it’s down about 1% since November 15. The situation is worse for growth stocks. For example, the S&P 500 Growth ETF (IVW) is down 2.6%, and the technology-heavy NASDAQ 100 ETF (QQQ) has been down 3% since the middle of the month.

Optimism that the Federal Reserve is poised to slow its rate and pace of interest rate hikes has shifted to worry the central bank will overplay its hand in battling inflation, driving the economy into a recessionary tailspin next year.

Certainly, there’s reason to think a recession is inevitable. Historically, it’s been a harbinger of recession when the 3-month Treasury bill yield exceeds the yield on the 10-year Treasury note. That yield inversion has preceded each recession since the 1960s, with recession emerging within one year of the initial negative spread. That’s discouraging, given the 10-year minus 3-month spread inverted in late October and stands at -0.61% today.

The potential for economic slowing alongside stubbornly high inflation puts investors in the crosshairs. If inflation falls, it would give the Federal Reserve cover to move to the sidelines and, eventually, start cutting rates. If not, higher rates for longer could mean stagflation, a major headwind for stocks.

A wait-and-see market

Stocks gapped higher when Consumer Price Index showed that inflation decelerated to 7.7% year over year in October, down nicely from 9.1% in June. However, stocks haven’t gained any ground since then because, while encouraging, that inflation rate remains at levels last seen in the 1980s.

For the market to build on its recent rally, we’ll likely need to see additional signs inflation is slowing, including ongoing declines in core Personal Consumption Expenditures price data (ex-volatile energy and food), the Fed’s favored inflation measure. We’ll also need more conviction that Fed leadership recognizes risk is shifting from inflation to economic distress.

Unfortunately, Fed Chairman Jerome Powell did little to encourage bulls today. In a highly-anticipated speech, he indicated December’s rate increase could be smaller yet continued talking tough on inflation, suggesting that the Fed’s terminal rate – the rate at which it will stop increasing – will be higher than it is now.

His tone increases the importance of tomorrow morning’s PCE report for October and the November jobs data on Friday. If core PCE is tame, perhaps the S&P 500 can mount another challenge of its resistance. If unemployment ticks higher, that could help cement thinking the Fed will be less of an impediment to stocks in 2023.

The need to see more to justify the next leg higher in stocks was reinforced by Real Money Pro’s Bob Byrne today. Byrne writes:

If you are an intraday swing trader or a multi-day/week position trader, your best bet is to remain firmly positioned on the sidelines…anytime you need to search high and low to find a few tradable stocks, it usually is an excellent time to reduce your activity dramatically. As a long-biased trader, I have a simple rule in all but the most volatile markets — to stay out of the market unless price is above the day timeframe volume-weighted average price. If we look at the intraday price action over the past two days on the SPDR S&P 500 ETF (SPY) or Invesco QQQ Trust (QQQ), we can see that sellers kept prices under VWAP for most of the past two sessions…when I look at individual charts, I don’t find much I want to buy….the charts, both from an index and individual security standpoint, tell me to be patient and sit on my hands.”

The Smart Play

The initial bullish reaction to Powell’s speech today suggests some investors were waiting for the catalyst to pass (sell the rumor, buy the news) before buying or covering shorts to flatten exposure ahead of PCE tomorrow. The real test will be how stocks act once investors have a few days to digest the various puts and takes from Powell’s speech, PCE, and Friday’s jobs report. So, resist the temptation to chase because you could easily wind up on the wrong side of the trade, especially since we’re bumping into resistance. Remember, there will be plenty of money-making opportunities once the market starts trending up or down again rather than chopping about as it has the past two weeks.

So far, value stocks have performed better since October’s low, and they’ve been more resilient over the past couple of weeks. For example, the iShares S&P 500 Value ETF (IVE) is up nearly 16% this quarter and 1% since mid-November. However, the iShares S&P 500 Growth ETF IVW is only up 5% this quarter, and it’s lost 2.6% of its value in the past two weeks.

Value’s relative outperformance isn’t too surprising, given investor de-risking favors lower-beta stocks, including those paying dividends. Value stocks are also more insulated against pain associated with devaluating future growth because of higher Treasury yields (a rising risk-free rate reduces the attractiveness of future cash flows in valuation models).