A battle royale for control of the tape

Preface: Explaining our market timing models 

The latest signals of each model are as follows:

Decision time

It’s nearing decision time. Both the S&P 500 and the NASDAQ 100 are forming wedge formations while testing their 50 dma supports. Will the market break up or down through the trend lines?
 

Upside or downside breaks would have strong directional implications. I believe the odds favour the bears. Here’s why.
 

Where’s the leadership?

Here’s what’s bothering me. The stock market advance in 2023 has seen three phases. The first phase was led by AI-related plays, as evidenced by the outperformance of NASDAQ 100 stocks (second panel). When enthusiasm for AI stocks began to stall in June, the S&P 500 continued to rise as leadership broadened out, as measured by the relative performance of equal-weighted to float-weighted S&P 500 and NASDAQ 100. Since then, leadership has narrowed again and the equal-weighted indices have lagged. But this time, the NASDAQ 100 is showing few signs of outperformance, which is disturbing.
 

Where’s the leadership?
 

The top five sectors by weight in the S&P 500 comprise over 70% of the weight of the index and it would be difficult for the market to meaningfully rise or fall without the participation of a majority. A detailed analysis of the relative performance of these sectors shows few signs of sustained outperformance or underperformance.
 

A detailed analysis of the cyclically sensitive value sectors shows only one sector exhibiting sustained relative strength. Energy stocks are rising on the back of higher oil prices.
 

Two potential worrisome chart patterns have appeared on my radar screen in the form of possible head and shoulder patterns with bearish implications. First, semiconductor stocks, which led the AI boom, are exhibiting a possible head and shoulders formation. While the neckline hasn’t broken and H&S patterns are incomplete and unconfirmed until the neckline breaks, the more disturbing development is the violation of relative support in the bottom panel.
 

A similar potential head and shoulders formation can be seen in the small-cap Russell 2000. While the neckline hasn’t broken to confirm the pattern, it has violated relative support with bearish implications.
 

It seems that commodity prices are the only part of the asset markets showing signs of life. In short, the only market leadership is in commodities – and energy in particular.
 

Bull markets simply don’t look like this.
 

Do valuations matter?

At the same time, Treasury yields are seeing upward pressure, which is an ominous sign for stock prices. Forward P/E multiples are already elevated. Rising 10-year yields are creating considerable competition for stocks. The 10-year Treasury yield is trading at a similar level as last October. Based on that data, the forward P/E should be about 15, which represents a -20% drawdown from current levels. Arguably, the forward P/E should be even lower based on a long-term history.
 

Even though the S&P 500 is facing valuation headwinds, it is enjoying a fundamental tailwind in the form of positive forward EPS revisions.
 

The week ahead

Looking to the week ahead, the macro highlight of the week is the FOMC decision on Wednesday. While the Fed is expected to hold rates steady, the risk is a signal of further rate hikes, or a hawkish hold.
 

The BoA Global Fund Manager Survey shows that expectations may be too dovish. Inflation expectations are rising even as respondents expect falling interest rates.
 

For what it’s worth, the coming week is the weakest week of the calendar on a seasonal basis.
 

In conclusion, I continue to believe the S&P 500 has unfinished business to the downside. The index can find support at its August lows at about 4350. Strong secondary support can be found at roughly 4200, which is about the site of the 200 dma.