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Incoming Inflation Data to Be Litmus Test for Equities

Is the market stronger than it looks?

CMT, Senior Market Strategist
Jul 10, 2023 at 8:00 AM
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While the bull thesis remains intact, last week’s volatility surprised many market participants. On Thursday, the ADP jobs report doubled estimates, shocking markets as the economy appeared stronger than previously assumed. Investors almost immediately priced in a 92.4% chance that the Federal Reserve will hike interest rates by 25 basis points during the Federal Open Market Committee (FOMC) meeting on July 25.

However, Friday's nonfarm payrolls report was cooler than expected, with markets briefly rebounding before selling off into the close. The jobs data-fueled rollercoaster had traders on their heels as they closed the holiday-shortened week, with markets now heading into July's most bullish week of the year, with consumer price index (CPI) and producer price index (PPI) readings on tap. 

"Over the past 10-years, July has been positive 90% of the time by an average of 3.1%, and in particular, the next two weeks being the strongest -- with this week being positive 80% of the time by an average of +1.22%, and next week being positive 90% of the time by an average +1.11%, over the last 10-years."

- Monday Morning Outlook, July 3, 2023 

CPI data comes out Wednesday and will be the next litmus test for equities. Expectations are that it will grow 0.3% month-over-month, but recent reports have come in weaker than anticipated. This CPI print seems more important after the Fed paused rate hikes in June. A hotter-than-expected number will likely shift market sentiment and could derail this rally. Alternatively, a weaker-than-expected CPI number could cause the Fed to punt a rate hike another month, especially if core inflation comes in below estimates.

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The S&P 500 Index (SPX – 4,398.95) exhibits some signs of exhaustion. Two of the most widely watched technical indicators, the Relative Strength Index (RSI) and the Moving Average Convergence Divergence (MACD), are currently in a negative divergence. This can signify that price may be in the early stages of reversing, but it could also mean consolidation. Divergences should never be acted upon without some technical break. This simply gives us a warning sign that near-term price action might not be as robust to the upside, or even potentially capped.

Moreover, bulls couldn't have been overjoyed with Friday's close, after equities gave up their gains. Yet, this was on low volume, so it wasn't panic selling, and directionally we still don't have a reason to short or hedge as price is holding those August 2022 highs at 4,290-4,300. Additionally, the island reversal pattern that occurred on Thursday's news I mentioned above already closed the gap – this is something traders don't expect to see when this pattern happens, as they expect continuation. So, it begs the question, is the market stronger than it looks?

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As I've previously mentioned, rotation is the lifeblood of bull markets. This week we continued to see sectors other than technology pick up the slack, with communication services positive by +0.80% and financials +0.71%. Seeing these cyclical sectors remain strong in the face of headwinds is a good sign for bulls that this is more rotation than distribution – at least in the short term. On top of that, defensive sectors are a mixed bag, with staples negative by -0.55%, utilities positive by +0.36%, and health care down -0.82%, indicating there isn't a rotation into safety trades yet.

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However, the CBOE Volatility Index (VIX – 14.82) popped more than three-year lows last week, the first sign of potential volatility in over a month. Nevertheless, the VIX quickly faded from the past two-year range lows and this year's spring lows, while barely budging off Friday’s lows despite the selloff.

One way to gauge complacency is by looking at the 10-day correlation between the VIX and the SPX. Currently, we are seeing a cluster of readings in positive territory. When this happens, we typically can expect volatility expansion in the near future. Sometimes it comes as a pullback in equities, and other times it's merely consolidation. Regardless, it's another warning flag that the rally has the potential to stall out soon.

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Last week we covered how the SPX advance-decline line staved off a potential failed breakout. This week, we will look at the McClellan Summation Index. It's similar in that it is calculated by stock advances and decline, but is calculated off the McClellan Oscillator.

Looking at the summation index, we've been in a clear uptrend since early June. The post-June options expiration seasonal weakness caused a minor dip below the 8-day moving average that was quickly reversed. Quick reversals have often brought on a sustained move in the current trend's direction. This is a boon for the bulls in the near term, despite rising risks.   

While risks continue to rise in this bull rally, nothing has significantly changed since last week. Investors should maintain long exposure until we see a technical breakdown below the SPX’s August highs between 4,290 and 4,300, where reducing exposure or hedging would be appropriate as we see how a larger pullback is absorbed.

However, we still saw momentum names run higher on technical breakouts last week. The playbook remains the same for now: Continue to target breakouts for near-term opportunities.

Matthew Timpane is a Senior Market Strategist at Schaeffer's Investment Research.

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