Market insights and analysis

By Tim Hanna

The major U.S. stock market indexes were up last week. The S&P 500 increased by 1.45%, the Dow Jones Industrial Average gained 1.46%, the NASDAQ Composite was up 0.98%, and the Russell 2000 small-capitalization index rose 1.79%. The 10-year Treasury bond yield fell 32 basis points to 3.56%, taking Treasury bonds higher for the week. Spot gold closed the week at $1,865.69, up 2.28%.

Stocks

Equity markets finished the week higher, closing out the first week of 2023 on a positive note. Gains came thanks to a rally effort on Friday after the release of positive economic data.

The economic data showed healthy job growth accompanied by slower growth in average hourly earnings. Nonfarm employment change came in at 223,000, higher than the 200,000 expected. Average hourly earnings month over month were 0.3%, lower than the 0.4% forecast. Investors speculate that the employment reports could indicate that the economy is on its way to a “soft landing,” or cooling inflation without a significant recession on the horizon.

In other economic news last week, ISM Manufacturing PMI came in at 48.4, slightly less than the 48.5 forecast. Values below 50.0 indicate industry contraction, while values above 50.0 indicate industry expansion. ISM Services PMI was 49.6, below expectations of 55.0. Unemployment claims were 204,000, below consensus expectations of 230,000. The unemployment rate came in at 3.5%, less than the 3.7% forecast.

The S&P 500 Index has been consolidating just under its 50-day moving average over the past couple of weeks. The Index remains in its downward-sloping bear price channel, but price is approaching the upper trend line (the black negative-sloping line on the following chart). The first level of resistance is at the 200-day moving average, which is right below the upper trend line of the bear channel. The 200-day moving average is a measure widely used by technicians to identify long-term trends and levels of support and resistance.

As markets hover around a potential key inflection point, there are a number of cases for the formation of either a bull trend or a bear trend. Still under the 200-day moving average and within a current death cross (when the 50-day moving average falls below the 200-day moving average), the S&P 500 is close to testing the upper level of the downtrending channel it set last year. A break of trend to the upside would coincide with a golden cross (when the 50-day moving average rises above the 200-day moving average).

Investor expectations of a soft landing could be wrong. Inflation could resurface following the Federal Reserve’s eventual pause. Interestingly, Bespoke Investment Group researched a number of equity market pros and cons as we start 2023.

Starting with the first pro: Bespoke found that the number of indicators pointing to lower inflation far exceeds those showing accelerating inflation. One example is the number of commodities in the ISM Manufacturing and Services report that are up or down in price each month. For more than 20 years, the three-month average of the net number of commodities rising in price has closely tracked the consumer price index (CPI) on a year-over-year basis. As the following chart shows, the commodities index has even led moves in the CPI.

While CPI is just starting to roll over, the net number of commodities rising in price has plunged into negative territory. Historically, when the net number of commodities rising in price has been negative, the average year-over-year CPI reading six months forward was just 0.8%.

The second pro is the U.S. dollar, which was in a consistent uptrend for most of last year before breaking down in the last quarter of 2022. The U.S. dollar has fallen more than 7% since the start of Q4 2022 and technicals are no longer bullish, which is good for U.S. equities. Conference calls during Q3 2022 earnings season mentioned foreign exchange as a major headwind during the quarter. With the decline in the U.S. dollar, expectations are that foreign exchange may be deemed a tailwind during Q4 2022 earnings reports.

The current presidential cycle is now going into year three, which brings us to our third pro: the election cycle. Since 1928, year two of the four-year presidential cycle has historically been the worst for the S&P 500. President Biden’s second year didn’t deviate from historical expectations. Year three has historically been the best, with the S&P 500 averaging a gain of 13.5%. Also, a Democratic president, Democratic Senate, and GOP House have been a good combination for stocks, as shown below.

Now, on to the bear cases. The first con: We are still in a bear market until we rally 20% off of the October low. In addition, this bear market so far has been below average from a percentage-change and duration perspective, with history suggesting that there could be another leg down. The S&P 500’s bear market low of the current cycle came on October 12. Over a 282-day period, the Index was down 25.4%. This is less than the post-WW2 bear market average decline of 32% over a period of 339 days.

The following chart shows that we’d have to rally up to mid-August highs to get out of bear market territory. A decline back to the pre-COVID high is around 11% lower than current levels, while a decline to the COVID-crash low would be a fall of around 41% from current levels.

The second con is that a variety of indicators that tend to be correlated with recessions are signals that economic contraction is coming. As mentioned, Friday’s ISM Services came in below 50.0. The only time a reading below 50.0 was logged without a recession was in the aftermath of the 2001 recession after the U.S. announced the invasion of Iraq.

Leading indicators are a composite of inputs that tend to lead the economy, and they are down almost 5% year over year. Since the 1950s, all previous declines of this magnitude have ended in recession. Also, the ratio of leading-to-lagging coincident indicators has plunged in recent months, another strong indicator of looming recession.

Along with a number of economic indicators signaling recession, the inverted yield curve, the third equity market con, continues to flash recession. The Federal Reserve follows the three-month/10-year yield curve closely, and this one is inverted by more than 100 basis points. Since the 1960s, there has always been a recession after an inversion of this magnitude. Also, one-year forward equity returns have historically been weak following such an inversion.

The pros and cons discussed here each make a strong case for the bulls and bears. How markets zig and zag to reach their terminal value, either up or down, for this year is an unknown. Dynamically risk-managed strategies are able to respond to changing market conditions as the changes are reflected in asset prices. As markets have moved higher since setting lows in Q4 2022 and experienced less downside volatility recently, a number of our momentum-based strategies have moved into more risk-on positioning. Strategies that were inverse have reduced or eliminated their short exposure. However, there has not been broad directional conviction across the board, which signals that the strategies are prioritizing risk management and are adjusting to changes in market conditions.

If prices continue higher with low volatility, systematic trend-following algorithms are designed to recognize the price momentum and participate in a risk-on fashion. If volatility resurfaces and prices turn south, systematic momentum strategies are designed to identify the change and move to more defensive positioning.

The following chart shows the one-year performance of the Quantified Managed Income Fund (QBDSX, -5.0%) compared to the iShares Core U.S. Aggregate Bond ETF (AGG, -12.9%). The Quantified Managed Income Fund is an actively managed income fund that can seek various income classes as well as the safety of cash when market exposure is undesirable. The Fund is a key defensive component in several actively managed strategies at Flexible Plan Investments.

Bonds

The yield on the 10-year Treasury fell 32 basis points, ending last week at 3.56% as the bond market continued to see relief from its battle with a long-term trend of rising interest rates. Last week’s large drop in yields puts the 10-year Treasury below its 50-day moving average (green line on the following chart), which was seen as a level of support for most of last year. However, there has been significant price action below since mid-November.

T. Rowe Price traders reported, “The investment-grade (IG) corporate bond primary calendar was active, … with the level of new deals exceeding weekly expectations. … Corporate bonds held up relatively well amid strong macroeconomic sentiment ahead of the Fed meeting minutes. After the release of the minutes, which were perceived as hawkish, technical conditions supported IG corporates. … High yield bonds, particularly BB rated issues, enjoyed strong demand. … The bank loan market was firmer amid generally positive investor sentiment, although trading volumes were somewhat light.”

Gold

Gold continued the momentum it started from its breakout in mid-November with a gain of 2.28% last week. The yellow metal is now trading well above its 200-day moving average. Last week’s move has helped the 50-day moving average get closer to a golden cross with the 200-day moving average.

Until November, the U.S. dollar’s strength (the purple line in the following chart) had made it difficult for gold to rally. A strong dollar is a restraint on global liquidity and a headwind for inflation in the U.S. In general, a stronger dollar lowers the price of imports. The U.S. dollar and other non-equity or bond exposures are available asset classes for consideration within certain strategies at Flexible Plan Investments.

While the fundamental case for gold in 2022 was strong as geopolitical tensions, recession fears, and the impact of Fed rate hikes held center stage, the technicals have not resembled that negative backdrop—that is, until the break of the long-term uptrend in November.

Flexible Plan Investments is the subadviser to the only U.S. gold mutual fund, The Gold Bullion Strategy Fund (QGLDX), designed at its introduction nine years ago to track the daily price changes in the precious metal.

The indicators

The very short-term-oriented QFC S&P Pattern Recognition strategy started the week with 60% long exposure. Exposure changed to 80% long at Tuesday’s close, 70% long at Wednesday’s close, and 40% long at Friday’s close. Our QFC Political Seasonality Index favored stocks throughout last week. (Our QFC Political Seasonality Index is available—with all of the daily signals—post-login in our Weekly Performance Report section under the Domestic Tactical Equity category.)

Our intermediate-term tactical strategies have been varied in their degree of defensive positioning. The key advantages these strategies offer to investors are their ability to adapt to changing market environments, participate during uptrends, and adjust exposure to more defensive posturing during downtrends.

The Volatility Adjusted NASDAQ (VAN) strategy started the week 20% short the NASDAQ and remained there to end last week. The Systematic Advantage (SA) strategy is 60% exposed to the S&P 500. Our QFC Self-adjusting Trend Following (QSTF) strategy was 100% short throughout last week but has now cut back to a neutral position. VAN, SA, and QSTF can all employ leverage—hence the investment positions may at times be more than 100%.

Our Classic model moved to defensive positioning at Wednesday’s close last week but returned to an invested position on Tuesday (1/10) this week. Most of our Classic accounts follow a signal that will allow the strategy to change exposure in as little as a week. A few accounts are on platforms that are more restrictive and can take up to one month to generate a new signal.

Flexible Plan’s Growth and Inflation measure is one of our Market Regime Indicators. It shows that we remain in a Normal economic environment stage (meaning a positive monthly change in the inflation rate and positive monthly GDP reading). Historically, a Normal environment has occurred 60% of the time since 2003 and has been a positive regime state for stocks, bonds, and gold. Gold tends to outpace both stocks and bonds on an annualized return basis in a Normal environment but carries a substantial risk of a downturn in this stage. From a risk-adjusted perspective, Normal is one of the best stages for stocks, with limited downside.

Our S&P volatility regime is registering a High and Falling reading, which favors gold over bonds and then stocks from an annualized return standpoint. The combination has occurred 13% of the time since 2003. It is a stage of higher returns and lower volatility for bonds relative to the other volatility regimes.