Risk-on: how long can it last?

The potential bullish call that we wrote in the last November article, developed in this period very quickly and in a manner far exceeding expectations. The favourable macro data we were talking about, and a certain benign attitude on the part of central banks, favoured the increase in both the stock market and bond markets, bringing long-term rates downwards.

But the speed and depth of the movements leave most market operators perplexed: the current price levels, especially on the long-term bond side, are discounting a scenario that is not the one indicated in the rate cut plans by the central banks. So, what can we expect in the next period?

We begin the analysis by resuming the graphs updated and published at the beginning of November: looking at the first graph, we can notice that the engine that lately continues to influence the movements of the stock market (S&P 500 index in the upper box) is always that of long-term government rates (10-year Treasuries in the bottom panel). The negative correlation therefore continues (as rates rise, the stock index falls - and vice versa). However, much attention must be paid to the historical moment: generally, this type of correlation, if core inflation falls below 4%, is reversed (i.e., when the stock market falls, government bonds resume their defensive function again, and in that case the rates also fall).

The short-term inversion of the ten-year curve, when it reached the psychological threshold of 5%, was favoured by a series of macro data, including lower-than-expected US employment data, which led the market to think that central bank rate cuts are now closer.

Currently the ten-year rates are on support around the 61.8% Fibonacci level (3.9% rate level), and the seasonal movement is very similar to what happened last year (see the two graphs’ areas with a green background).

The S&P 500 index has overcome the important congestion area that we had indicated in the previous article around 4,350/4,400 (horizontal pink dotted line), has reached the first price target (horizontal pink solid line) corresponding to the width of the short-term bearish channel (indicated with the red dotted lines), and is heading towards the upper part of the medium-term channel (blue dotted lines).

How much room can this rally still have in the equity sector? If we look at the trend of the market's breath through a check of how many stocks in the index are currently above the 200-day moving average, we can see in the lower panel of the graph below, that we are around the 75 level, which acts as a bit of a watershed. In the last 5 years, every time the indicator has arrived around this level, we have had in 11 cases the formation of a market high (the last time, it happened this year in the month in August), and in two cases a continuation of the bullish market.

To have the third statistical case of a continuation of the stock trend, we need to understand the setting of long-term rates for the foreseeable future. However, a pause on the part of the markets, or even a certain retracement, cannot be ruled out in the next period. The prices on the share side had very rapid increases on certain days which, as we had reported, created gaps (read the November article on the topic). Statistically, most price gaps are covered in the subsequent period, but this has not yet happened. This, therefore, favours the vision of a market that still wants to rise, although most indicators are in extreme positions.

An interesting fact, which comes from the observation of the relative strength of the Growth sector compared to the Value sector, is indicating a new phase of prevalence of the latter.

Looking at the graph of the last year relative strength ratio, we can see that the indicator has made a reversal with a bearish head and shoulders pattern, also exiting the 2023 bullish channel. A sector rotation could favour the continuation of the stock trend.

If we look at the curves of the main bond futures (US Treasuries, German Bund, French OAT and Italian BTP), we can see that the prices had, in terms of percentage increase, the same performance that occurred at the end of 2022 (see the areas indicated in the ellipses of the various graphs). However, the situation in terms of indicators is very different: currently all markets have exceeded the 200-day moving average, and the short-term oscillators (RSI), unlike the situation in 2022, have managed to exceed the level of 70 (except for the US Treasury which will need to be followed carefully in the next period). The MACD is also well set, which was not the case in 2022.

If we look at the graph of the ten-year Treasury with a longer time horizon (monthly data), we notice that the divergence we talked about anticipated the price reversal. It remains to be seen how strong it will be in the next period, given that it is happening in a bearish market anyway. I have marked on the chart with green parabolas, a developing potential head and shoulders pattern. If the pattern works, we will have the 3.25% level as a potential confirmation of a trend reversal (the area in previous graph 1 from which the first Fibonacci baseline starts - in red - which corresponds to the April low).

The greatest risk within this scenario is represented by the geopolitical variable, which in turn is closely linked to the price of oil. Ten-year government rates and the price of oil have recently been positively correlated. A significant rise in oil could bring ten-year rates back to the 5% zone or even higher. Below is a graph to note the similarity in the performance of Light Crude Oil (upper box) with the ten-year Treasury rate (lower box).

In summary, prices are confirming the rise anticipated by indicators and macro data at the beginning of November. However, the bond market has moved too quickly and is also pricing in a different scenario than the one announced by central banks. The indicators are all very tight. A pause or partial reversal by the financial markets is therefore possible. What is important for the S&P 500 index are the supports at 4,400 (congestion zone from which the current trend started), and the fundamental minimum at 4,100. It's time to think about value stocks too. Regarding 10-year rates, we have important support at 3.25%, but before a new potential impulsive wave towards that price level, it is reasonable to think about a retracement. Particular attention must be paid to the price of oil which could become, in small doses, a diversification asset within the portfolio (sustainability permitting...).

About the author

Mario Valentino Guffanti is a board member and Head of the Lugano Chapter. He is a financial advisor, technical analyst and researcher based in Milan, Italy. As an author of technical articles and lecturer as well as instructor in technical analysis courses in Switzerland, he is also dedicated to financial coaching through NLP techniques (neuro-linguistic programming).