The market is pricing in Goldilocks, enjoy it while it lasts
A return of pro-cyclical leadership has been the main differentiating factor for this rally compared to the bear market rallies we have seen over the past year. Though the outlook for economic growth is poor and the economy does continue to slow, the market is taking these dynamics in stride and doing its utmost to price in a Goldilocks regime.
Thanks to the China reopening, resilient households, a robust services sector and tight labour market, we may be entering into a period where these bullish trends (or perhaps more accurately described as less bearish) help delay any recession until the second half of the year and put a floor under markets for the time being.
After a poor 2022 and the significant breadth of bearish positioning seen throughout, the markets are making the most of any Goldilocks type data with the pro-cyclical areas of the stock market leading the way higher.
Though not always correct, such measures of market internals are generally a good indicator of the health of the market and provide insight into future price action.
As we can see below, investor risk appetites and the relative performance of the most cyclically sensitive stock market sectors are nearly all confirming the recent highs. This did not occur to such a degree during the July nor November rallies.
From a technical perspective, it is hard not to notice the changes in the underlying price action in recent months compared to the clear downtrend which has encompassed the past year.
As discussed, the market is trying its hardest to rally in a sustainable manner, and for now, the pricing in of a China reopening and resilient economy has spurred an increased probability of a period of “transitory Goldilocks”, of which nobody was positioned for, allowing the S&P 500 to go on to make a number higher lows since October.
With a potential breakout of the downtrend line underway, 4,100 looms large as the next point of obvious overhead resistance, and seemingly an excellent area to reassess whether the market has overpriced these bullish developments.
With pro-cyclical leadership coming to the fore in recent weeks, we would expect to see small caps and thus the Russell 2000 outperforming. This has certainly been the case through January, with the IWM ETF again testing an important overhead resistance level of around $187.
A level which also coincidences with its recent downtrend line. If the breakout in momentum is any clue (as proxied via price vs. the 50-day moving average), then a bullish breakout is looming.
Also of note have been the number of bullish breadth thrusts triggering during this rally. Admittedly, such measures have lost some of their efficacy in recent months as a number of false signals occurred during 2022, but alas, broad-based breadth such as what we are seeing remain an important consideration as they signify healthy market internals.
Most notably, the average of the 10 and 20-day number of up-versus-down stocks on the NYSE has triggered another bullish reading, as we can see below. The broad-based nature of this rally throughout the entirety of the world’s various stock markets is also notable.
In terms of net liquidity, we may see continued short-term relief as the US Treasury moves to draw down their Treasury General Account, which the Treasury has signaled their intention to do so as the debt ceiling approaches.
A reduction in the TGA would boost dollar liquidity as this would in effect be a transfer of reserves from the Fed’s balance sheet to bank balance sheets, temporarily offsetting Fed QT.
What too could be viewed as bullish over the coming months is seasonality, with March and April in particular favourable months for stocks historically. However, when we view seasonality on a conditional basis through the lens of bear markets only, the appeal of seasonality becomes less enticing.
The bullish catalysts
A resilient consumer, a strong services sector, falling inflation, China stimulus and strong labour market are all material and impactful dynamics investors need to consider and understand when making their asset allocation decisions for the months ahead.
Although the outlook for economic growth remains dreadful, these aforementioned dynamics have the potentially to continue to put a floor under growth for the next three to six months whilst also resulting in this cycle playing out slower than expected. Investors were not positioned for this outcome, and as we have seen, the market is beginning to only now price this in.
Nowhere is this economic resilience more notable than within the services side of the economy. Remember, the services sector is responsible for roughly 80% of all…
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