Equity markets continued their march higher last week as the dollar continued its selloff. 

The S&P 500 is now up 6.5% on the year, one of the best starts to a year ever. The S&P’s return, however, has been dwarfed by the returns of the Nasdaq 100 (12%), the Russell 2000 (9.3%), the MSCI Developed Markets Index (8.1%), and the MSCI Emerging Markets Index (10.7%). And then, of course, there’s bitcoin, up 40% so far in 2023. 

Can the party continue? 

Our belief is, “yes, but….”

We believe caution is warranted for two reasons. 

The first is that a broad array of markets—various equity indices, sectors, gold, the dollar, etc.—are at important resistance levels (or in the case of the dollar, support levels). And, many of those markets are overbought at resistance levels—a double whammy.

Typically, a market won’t break through important resistance on the first try (unless it’s accompanied by some exogenous event). Thus, in the near term, it’s reasonable to think equities and gold will pull back and the dollar will bounce. 

If this were to occur, it would likely lead to a healthy, welcome, and much needed reset of sentiment. 

The second reason we believe caution is warranted is that next week is shaping up to be a monumental week for markets in terms of the sheer volume of market-moving news. 

In the words of Bank of America:

“Next week is one for the record book. We have not seen these three major central bank decisions (Fed, [Bank of England], [European Central Bank]) and key data releases (US ISM, payrolls, and the employment cost index, as well as Euro Area inflation, GDP, and confidence data) in the same week before.”

That’s a big week. But BofA left out the fact that Apple, Amazon, Google, and Meta will also release earnings reports next week. 

With all those data events, it’s not hard to imagine that at least one will come in unfavorably. For an overbought market at resistance, it would likely take only one unfavorable event to send it downward to regroup.

If the market does pullback, however, we would expect it to eventually stabilize  and move higher for the following reasons:

1. Smart money seems to be in no hurry to adjust its positioning in growth- and liquidity-related assets. In particular, institutions are extremely bullish equities relative to retail traders, and smart money speculators are not lessening their bearish positioning in the dollar.

2. We are in the early days of several breadth thrusts that historically have been uniformly bullish for equities over multi-month horizons.

3. As Mike Hartnett, Bank of America strategist puts it with respect to the wrong-footed positioning of speculators and retail traders in equities, “Another 3-5% [higher] will feel like bathing in lava if you’re a bear.”

4. We saw a stat this weekend posted by@MacroAlf that indicated the S&P 500 trades at a 17 multiple to forward earnings. But, if we exclude the top six companies in the index (AAPL, AMZN, MSFT, etc.), the “S&P 494” trades at only a 13 multiple to forward earnings. The average trough multiple for the S&P 500 during recessions is—you guessed it—13. Thus, there appears to be room for multiple expansion—especially if the market believes the worst is over in terms of tightening financial conditions and slowing growth (e.g., China’s reopening may have the market pricing in a growth rebound). {Note: many people in the comments questioned the validity of the statistic.]

5. While everyone has been waiting for the Fed to pivot, the U.S. Treasury pivoted back in mid-October, the week equities bottomed and the dollar topped (and perhaps not coincidentally, the week institutions went all-in on equities and speculators turned bearish on the dollar).

Wait, what? The U.S. Treasury pivoted back in October? Yes, according to independent macro strategist, Luke Gromen. In his weekly research report, Gromen notes the following chain of events:

1. October 11: U.S. Treasury Secretary, Janet Yellen (former Fed Chair) said the U.S. Treasury (UST) market was “functioning well.”

2. October 12: Just one day later, Yellen said she was worried over the loss of “adequate liquidity” in the UST market—a change of tune in less than 24 hours.

3. October 10-14: IMF meetings in Washington where global participants were reported to have had stern words for Washington officials about the strength of the U.S. dollar (USD) and the economic damage it was causing.

4. October-January: Yellen’s Treasury has run down the Treasury General Account, spending that money into the economy and, in the process, loosening financial conditions and weakening the dollar.

5. Fall-Winter 2022/2023: Both the ECB and BOJ have taken a more hawkish monetary policy stance, while the Fed nears the end of its hiking cycle.

Gromen notes that “We now know too strong a USD causes UST market dysfunction.”

He concludes:

“We continue to hear ‘Powell is worried about his legacy; he wants to be Volcker, not Burns,’ but Volcker never had to worry about the strong USD hurting UST market functioning—Powell does.”

“This in turn yields a powerful conclusion we can use as a North Star for this cycle: Unless Powell is willing to stand aside and let the US government default on USTs, he CANNOT be Volcker; his only choice is Burns.”

Thus, while a pullback in the near term would be natural, we would eventually expect risk assets to regroup and make another attempt at breaking through resistance. If investor positioning remains as it is currently, we would further expect that next attempt to be successful.

In the interim, however, let’s all buckle up for what is likely to be a volatile week ahead.