XLK - S&P 500: Bullish Momentum Is Waning (Technical Analysis)

2023-11-29 09:26:35 ET

Summary

• U.S. equities have rebounded forcefully since we reiterated our bullish view back in October when the S&P 500 Index was experiencing a minor pullback.
• The S&P appears to be losing momentum as it begins to stall. Furthermore, big technology themes are once again dominating the rally, with valuations beginning to look stretched.
• We see increasing risks of another short-term pullback on the S&P and see an opportunity to tactically reduce big tech exposure on stretched valuations.
• Overall, we remain constructive on U.S. equities but prefer to overweight undervalued themes, including residential REITs, healthcare, and biotechnology.
• We downgrade our rating on the S&P to "Buy".

U.S. equities have rebounded forcefully since we reiterated our bullish view back in October when the S&P 500 Index ( SP500 ) was experiencing a minor pullback (see "S&P 500: Mild Pullback Sets Stage For Strong Finish To 2023" - Oct 3, 2023 ). The S&P is currently up 18.6% year-to-date and looks set to close the year at around current levels.

Initially, we were rather concerned to see the S&P trading briefly below the lower trendline of its bull flag pattern between 26-31 October (annotated in chart). Coincidentally, the S&P had also fallen below its 50% Fibonacci Retracement level extending from the January 2022 peak to the market bottom in October 2022.

Not only would a sustained sell-off from those levels confirm a failure of the bull flag pattern, but it would have also signaled a potential reversal of the bull market. Fortunately, that turned out to be a false signal and the SPX rebounded and quickly regained its bullish momentum. The S&P has since broken above several key technical levels and is now just a whisker away from our long-held year-end target of 4,600 points .

Losing Momentum

Having said that, the S&P appears to be losing momentum as it begins to stall at just above 4,550 points. Furthermore, big technology themes are once again dominating the rally with valuations beginning to look stretched, adding to the risk of another pullback.

Lately, our own observations on market sentiment also suggest that investors are apt to chase short-term returns by crowding into winners but remain unconvinced that macroeconomic fundamentals will improve. This suggests to us that in the event of a pullback, big technology names are more likely to underperform.

For the bull market to be sustainable we would prefer to see a much broader rally across some of our favourite undervalued themes including residential REITs, healthcare, and biotechnology.

Even in the event that we are wrong on big technology, we would still expect the undervalued themes to outperform over the medium term (within the next 1 to 3 years).

Therefore, we see little risk in tactically rotating out of technology and into the undervalued themes, especially residential REITs. A tactical shift at this juncture will allow investors to realize the fantastic gains on some of these technology names to date and to position their portfolios for even greater gains ahead.

The Same Contrarian Play All Over Again

Trading market sentiment has worked exceptionally well for us in recent years, as sentiment swung repeatedly between the extremes of fear and greed. We still expect this simple contrarian strategy to work well until there is much more clarity on the economy and monetary policy, which is only likely to come in Q2 2024.

As CNN's Fear and Greed Index shows, market sentiment is greedy at this moment, as expectations for an early rate cut by the Federal Reserve are building on the back of cooling inflation data and weakening economic activity.

Admittedly, we were wrong to expect a rate cut by the end of this year. And it seems increasingly likely that the Federal Reserve will err on the side of caution by sticking to its dot plot projections for a rate cut in June 2024. However, this increases the risk that a delayed cut will throw the U.S. economy into a mild recession, adding to our view that we could see more volatility in equities. Nonetheless, given that there is room for the Federal Reserve to cut more aggressively if needed, we see limited risk to equity returns longer term.

To be clear, we maintain a constructive outlook on the U.S. economy and U.S. equity returns in general. Our base case is for inflation to continue to cool and that we are long out of the woods in terms of stagflation risks. However, we do appreciate that market sentiment remains cautious and we are therefore likely to experience heightened volatility heading into 2024. Cautious market sentiment also means that our favourite undervalued themes may need more time to materialize. We see REITs as the asset class that will give the best risk-adjusted returns over the next 1-3 years.

In Conclusion

We see increasing risks of another short-term pullback on the S&P and see an opportunity to tactically reduce big tech exposure on stretched valuations. Overall, we remain constructive on U.S. equities but prefer to overweight undervalued themes including residential REITs, healthcare, and biotechnology.

Accordingly, we downgrade our rating on the SPX to "Buy".

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