Federal Reserve Chair Powell fired a warning shot last week in its FOMC meeting, implying the Fed is concerned about rising inflation. Minutes from the policy meeting set the stage for a rate hike as early as March, an end to easy-monetary policies, and reducing the nearly $9 trillion Fed balance sheet.
The Fed news did not surprise investors as many expected it. The real problem with Chairman Powell's comments is that it now sets the stage for a period of uncertainties in financial markets as to how sharply the central bank will raise rates. Specifically, investors will have around six weeks to digest how much rates will climb in 2022 and how aggressive the Fed will shrink its balance sheet to fight rising inflation. Without a clear road map to the Fed tightening process, financial markets will be increasingly volatile over the near term.
After a tough January, most equities are either flirting with corrections (10%), deep corrections (10-20%), or cyclical bears (20%-plus). The recent drawdowns may continue as investors digest a more hawkish stance from the Fed and mixed economic and earnings news. However, market indexes are unlikely to enter structural bear trends unless the U.S. economy slips into another recession.
Corrections and deep corrections are common in U.S. market indexes. If the U.S. economy remains in a recovery mode, then the drawdowns are consolidations within the framework of a secular or structural bull trend.
The losers in January have been growth, small caps, and Nasdaq markets. With the recent bounce from 1/24/22 low, the NASDAQ Composite Index (COMPW) has fallen -10.06% and continues to be in correction territory. The Nasdaq 100 Index (NDX -9.52% YTD), the S&P 500 Growth Index (SGX -9.13%), and the S&P 600 Small-Cap Index (SML -9.13%) are also trading near correction levels. At the worst point on 1/24/22 low, COMPQ declined -19.23% on an intra-day basis. On 1/28/22, the Russell 2000 ETF (IWM) briefly slipped into a bear market territory, falling 22.83% from its Nov 2021 record high.
The S&P 500 Index (SPX) also traded below its correction level of 4,336.76 (-10%) intraday. However, the large-cap index rebounded above the correction threshold on a closing. The recent rally on Friday, 1/28/22, and Monday, 1/31/22, has now powered SPX back above its 200-day ma (4,436.69). SPX is only 6.29% below its all-time high, putting the index further away from the correction territory.
SPX appears to be establishing a potential technical base via a higher-low pattern (i.e., 1/24/22 low is 4,222.62 and the 1/28/22 higher-low is 4,292.46). The short-term technical indicators also show signs of improvement. For instance, the MACD price momentum indicator appears to be bottoming on 1/27/22. A cross-over to the upside will confirm a momentum low. The RSI overbought/oversold indicator (RSI) fell to a low of 23.5%, also on 1/27/22, signaling a deeply oversold market condition ready for an oversold rally. At a current RSI reading at 46.40, there is room for the indicator to trade upwards before reaching overbought levels again (70%), implying further SPX price gains near-term. The Accumulation/Distribution indicator has entered into a sideways trading range, suggesting the supply/demand picture is improving. The Advancing minus Declining Issues indicator or market breadth has broken its Sept 2021 uptrend, indicating a poor market breadth trend. However, the ability of this indicator to surge and stay above its previous breakdown level suggests a false breakdown and improving breadth. VIX index has risen too sharply toward the low-30s. The recent pullback suggests market fear may be abating as it returns to its best fit line near 22.
Based on the premise that a recession is unlikely, this is a correction, deep correction, or a cyclical bear. Nonetheless, the market actions over the next few days or weeks will give a better guide to the potential for market recovery and the scale of the decline. Remember, market bottoms ex V-type patterns is often a process to develop a technical base sufficient to allow for the resumption of the primary uptrend.
One of the keys to defining a market bottom and the resumption of the primary trend is how the market trades as it nears resistance(s) on subsequent rallies. Key resistance is more meaningful when numerous technical levels converge near the same area (i.e., moving averages, trendlines, retracements, prior breakdowns, high volume, etc.).
Key resistance for SPX converges near 4,591-4,669, coinciding with the 61.8% retracement (4,590.95) from 1/4/22-1/24/22 decline, the 1/4/22 downtrend (4,621), the 50-day ma (4,632), and the extension of the Oct 2021 trendline breakdown (4,669).
Another battle will likely develop as SPX nears this critical resistance in the days and weeks ahead. The bears will likely emerge here to defend their bearish positions. A breakout favors the bulls, signaling the next SPX rally toward 4,744-4,479 (11/22/21 and 1/12/22 highs or left/right shoulders), and above this to a retest of 4,818.62 (1/4/22 all-time high). A new higher-high confirms the resumption of the primary uptrend.
On the downside, the 200-day ma (4,437) remains technical support as the ability to maintain above its key moving average suggests the primary uptrend remains intact. The 10% correction threshold at 4,336.76 is another support as it remains a psychological barrier that plays into the psyche of investors' and traders' mindsets, at least on a near-term basis. The 1/24/22 low at 4,222.62 is a reaction low that may lead to a market bottom and the start of the next bull rally. On the other hand, violation warns of a deeper correction or a cyclical bear decline.