AFMC - The Stock Market May Be Topping Again

2023-04-05 11:03:43 ET

Summary

• The S&P 500 and stocks generally have put up a significant rally (19% for SPX).
• However, while quality tech stocks may have bottomed, other essential market areas have not.
• There's considerable risk that a recession, increasing defaults, a consumer spending slowdown, and persistent inflation could enable another drop in the stock market.
• The fundamental backdrop needs to improve for stocks, and it may require more significant signs of a Fed pivot before the primary recovery phase starts.
• My bear-market "bottom buy-in" range remains around the 3,400-3,000 support level.

The S&P 500/SPX ( SP500 ) may have reached another near-term top. No, I'm not saying this because of the deteriorating technical image. I'm very concerned about the well-being of the U.S. economy in general. If Main Street stalls, Wall Street could suffer, and as specific banks face and deal with certain issues, increasing defaults could cause volatility spikes in the coming months. Everyone is asking about what shoe could drop next.

Well, that next shoe could be a significant rise in default rates accompanied by a worsening consumer due to the dual factor of high inflation and increased borrowing costs due to a tight monetary environment.

Therefore, due to the ongoing economic challenges, worsening sentiment, and deteriorating technical factors, the stock market could experience a substantial correction, possibly bringing the SPX back down for a re-test of the 3,500 or to new lows (3,200-3,000 range) in a worst-case outcome.

Technical Issues Evident: Breakdown Appears Probable

SPX: 1-Hour Chart

Unless the SPX can break through the 4,200 resistance level, stocks could reverse and head lower in the near term. We've seen about a 10% move in the SPX since the recent low of around 3,800. Furthermore, if we analyze SPX's longer-term activity, the major average appreciated by approximately 19% from its "bear-market" low, around 3,500, to its recent highs.

Let's Look at Another Chart

SPX: 1-Year Chart

The SPX rallied nearly 20% from its major low in October to its recent high in early February. Some may call this move the beginning of a new bull market. However, it's likely a significant bear market rally, and the SPX could have more room to slide.

Don't get me wrong, some stocks likely bottomed. I don't think we'll be seeing Tesla ( TSLA ) at $100, Nvidia ( NVDA ) at $105, or Meta ( META ) below $90 again. Therefore, the high-quality tech stocks may have bottomed, but other significant market areas may not have reached the bottom yet. Therefore, we should see significant buying opportunities in various sectors, including technology stocks, on pullbacks as we advance.

Technically, the SPX appears overbought here, and stocks lack a sufficient catalyst to propel prices significantly higher in the near term. The RSI, CCI, full stochastic, and other technical indicators imply that a downturn is coming soon. This dynamic doesn't suggest that we're moving eminently lower to new lows (yet), but we should remain cautious as selling pressure will probably increase soon. Moreover, if the SPX doesn't break out above 4,200 soon, it will form a bearish head and shoulders pattern, another negative technical element to consider.

What Concerns Me?

- Please Allow Me To Present Several Charts

By far, not all significant U.S. companies have excellent credit ratings . On the contrary, many companies are in the B-BBB and even the B- range. This dynamic illustrates that corporate credit ratings are worsening. Many companies will need to consolidate debt obligations in a higher interest rate regime, leading to higher-than-anticipated debt payments and an increased risk of defaults.

The Next One - Yield Rise Alarming

While the substantial rise in corporate yields is alarming, it's not surprising, provided the challenging macroeconomic environment and a tight monetary atmosphere. Junk bonds have roughly doubled from 4% to 8% since 2022 began. Perhaps worse so, we see a similar dynamic with "investment-grade" corporate bonds, as yields rise from around two to more than four percent.

This Chart Worries Me the Most

The U.S. "speculative-grade" default rate is around a historic low, and this phenomenon is troubling. First, I want to point out that, historically , exceptionally low levels of junk defaults occur before or around recessions. Higher interest rates for longer policy should continue contributing to rising defaults. Some analysts, including those at BNP Paribus, expect the junk default rate to rise to 5% in 2023 and persist through 2024 until the elevated interest rate pressure is relieved.

Inverted Rates - Another Recessionary Signal

We see the nearer-term Treasury yields surging past longer-dated Treasuries as investors search for haven in long-term bonds. We often see similar rate inversions before recessions as investors attempt to lock in better yields for their long-term bond portfolios. This dynamic also implies that the Fed may be close to pivoting on interest rate policy, which would further press down the yield on longer-term Treasuries.

Bad News Is Bad News Again

For a while, the market became accustomed to lousy news equating to good news. This phenomenon occurred due to the market pricing in lower probabilities for higher interest rates as economic news soured. However, we may be at an inflection point where the market may react unfavorably to awful news again. For instance, there's a crucial jobs report coming this Friday.

Friday's Jobs Report

Last month (last reading), the labor market added 311,00 jobs. While this figure was above consensus estimates, the stock market reacted relatively favorably. The market hasn't reacted negatively to many economic readings outside higher-than-expected inflation prints. This dynamic may persist as the most significant readings are not screaming recession yet.

However, the market would react unfavorably to a worse-than-anticipated labor market, as it would illustrate a clear and present danger to the consumer and other critical elements of the economy. The market is looking for approximately a 240K increase in the labor market, but the stock market may drop if this essential reading comes in below 100-200K. Furthermore, as we advance, a worse-than-expected labor report could imply future downward revisions and more misses in labor market data, leading to lower stock prices.

Valuations - Still Far From Cheap

First, let's outline that we're coming off the highest CAPE level since the absurdly high 44 levels reached in the Dotcom days. The CAPE's recent high during the height of the bubble was in the 37-38 range. It's constructive that valuations have come down moderately, but we haven't seen anything resembling a great reset.

Many quality technology stocks got sold (panic selling) to extremely oversold and undervalued levels, but many stocks may not have seen their lows. We could see the CAPE continue coming in until reaching around the 22-24 level next. This dynamic implies that the SPX could experience another drop of approximately 20-25%, suggesting that a true bottom to the bear market may arrive around 3,400-3,000 in the coming months.

Furthermore, my estimates may be conservative, as downside overshoots could cause significant selling panic selling and capitulation, bringing major averages and individual stocks to lower-than-anticipated levels.

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