Are the pros getting defensive? … how to analyze trader sentiment … what sector analysis reveals about whether or not Wall Street is worried

 

In yesterday’s Digest, we mentioned the dreaded “R” word – “recession.”

And today’s lackluster earnings from Apple and Amazon don’t inspire confidence that this idea is laughable.

Fortunately, the conclusion we took from famed investor, Louis Navellier, is that the U.S. is likely to escape a recession (other countries around the globe may not be so lucky).

In today’s Digest, let’s look at this question from Wall Street’s perspective.

Specifically, if Wall Street believes we’re careening toward a recession, we’d likely see increasingly defensive positioning in stocks.

On the other hand, if Wall Street isn’t particularly concerned, we’d see greater “risk on” allocations.

Sounds simple enough. But is this analysis truly that easy?

From our technical experts, John Jagerson and Wade Hansen:

The stock market is not easily predictable. It’s difficult to look ahead three, six, or 12 months and guess exactly where the stock market is going to be.

However, Wall Street doesn’t have a great poker face. It has quite a few tells when it starts making significant bullish and bearish moves. You just have to know where to look.

Fortunately, it turns out Wall Street’s “tells” have been showing.

Today, let’s see where John and Wade suggest we look to gauge bullish vs bearish sentiment from the pros – which we’ll extrapolate as clues about recession fears. More importantly, let’s see what it means for your portfolio as we move into the final stretch of the year.

***Are Wall Street bears taking charge based on recession fears?

For newer readers, John and Wade are the analysts behind Strategic Trader. This premier trading service combines options, insightful technical and fundamental analysis, and market history to trade the markets, whether they’re up, down, or sideways.

In Wednesday’s update they pulled back the curtain on Wall Street’s poker face:

One of Wall Street’s biggest tells is how it treats each sector within the stock market when it transitions from bullish to bearish, or from bearish to bullish.

The illustration below shows which stock sectors tend to outperform during various phases of the Business Cycle.

As you can see, the stock market tends to favor financials, consumer discretionary, technology, basic materials, and industrials sectors when it transitions to – and maintains – a bullish uptrend.

Conversely, the stock market tends to favor the energy, healthcare, consumer staples, and utilities sectors when it transitions to – and maintains – a bearish downtrend.

So how has the market performed since September 30 when the S&P 500 broke through support and completed its head-and-shoulders bearish reversal pattern?

Before we continue, let’s make sure we’re all on the same page about this bearish head-and-shoulders pattern, because it sounds a bit ominous on the surface.

At the beginning of the month when John and Wade identified the formation of this pattern, they noted how bearish head-and-shoulders patterns fail so often that back-testing reveals they’re an effective contrarian indicator.

John and Wade ran this back-test themselves, spanning the last 18 years. They identified each head-and-shoulders pattern within that time-frame. But then rather than sell stocks based on this “bearish” pattern, they bought stocks.

It turns out the system outperformed the S&P by 32%.

***Returning to the question, how has the S&P performed since completing the latest head-and-shoulders pattern?

From the Strategic Trader update:

All of the sectors you would expect to see outperforming during a bullish uptrend are currently outperforming.

Most of the sectors you would expect to see underperforming are currently underperforming.

You can see this for yourself.

Below, we look at a comparison chart John and Wade provided of the ten S&P 500 sectors, and the S&P 500 itself (tracked by State Street Global Advisors through their Select Sector SPDR funds).

Here’s the performance since September 20 through earlier this week:

• Energy Select Sector SPDR® Fund (XLE): 13.53%
• Consumer Discretionary Select Sector SPDR® Fund (XLY): 10.09%
• Materials Select Sector SPDR® Fund (XLB): 8.61%
• Financial Select Sector SPDR® Fund (XLF): 8.18%
• Real Estate Select Sector SPDR® Fund (XLRE): 8.10%
• Technology Select Sector SPDR® Fund (XLK): 6.74%
• Industrial Select Sector SPDR® Fund (XLI): 6.69%
• SPDR® S&P 500 Fund (SPY): 6.25%
• Utilities Select Sector SPDR® Fund (XLU): 5.39%
• Health Care Select Sector SPDR® Fund (XLV): 4.07%
• Consumer Staples Select Sector SPDR® Fund (XLP): 3.85%

Back to John and Wade:

The odd standout is XLE; it is outperforming all of the other sectors because crude oil prices have been on a bullish tear since late August.

Any time you see crude oil prices climbing that dramatically, stocks in the energy sector are going to thrive.

So far, so good. No sign here of recession fears manifesting as defensive sector positioning.

***What we can learn about Wall Street’s outlook by examining leverage

For the next crack in Wall Street’s poker face, let’s go straight to John and Wade:

One other tell Wall Street has is how much money it is borrowing to buy stocks.

Borrowing money to buy stocks is referred to as buying on margin, and the amount of money you have borrowed to buy stock is called “margin debt.”

Tracking the total amount of margin debt being used on Wall Street to buy stocks can give you a good sense of how confident traders are.

Confident traders tend to borrow more; nervous traders tend to borrow less.

John and Wade report that about this time last month (these are the latest numbers from FINRA), Wall Street had levered up to $903.1 billion to buy stocks.

Of course, this number means little without context. So, the chart below dating back to 2016 will help you with the takeaway – this is a colossal amount of margin debt.

Here’s John and Wade with further insights:

As you can see in the graphic above, this is down slightly from the $911.5 billion that Wall Street borrowed as of August 21.

But when you consider traders only unwound $8 billion in borrowings while the S&P 500 was pulling back and completing a head-and-shoulders bearish reversal pattern, it appears confidence is still high.

Based on the dramatic bullish recovery of the S&P 500 the past few weeks, we fully expect the margin debt numbers to rebound to new highs when we get the October numbers next month.

***It’s appearing that, per tradition, the market is righting itself after stumbling in the fall, getting ready for a bullish push to end the year

From the two clues John and Wade highlighted, it appears Wall Street pros aren’t bearish at all…which tempers recession fears.

If anything, we’re simply coming out of a seasonally-weak time of year, entering a seasonally-strong time of year.

Economist Ed Yardeni recently published research on the average percent changes in the S&P 500, by month, between 1928 and 2021.

As you’ll see below, September is hands-down the worst month for stocks. October is only middle-of-the-pack. But November and December are strong months.

Bottom-line, yes, at some point we’ll face a recession because that’s the nature of economic cycles.

But if we go by Wall Street’s bullish clues, as well as the seasonally-strong months we’re about to enjoy, it’s not time to let recession fears knock us out of the market.

We’ll continue to keep you up to speed here in the Digest.

Have a good evening,

Jeff Remsburg