SPY: Early CPI Euphoria Dissipated

Today's (April 12) CPI release led to an initial wave of optimism in pre-market trading that quickly dissipated. The S&P 500 Index (SP500) has continued to stall at its December 2022 bull trap highs or false upside breakout.

The 410 level on the SPDR® S&P 500 ETF Trust (NYSEARCA:SPY) rejected bullish advances in February and has stalled the SPY's advance since last week. While a near-term top cannot be ruled out, the risk/reward of a sell signal doesn't seem to be favorable enough.

What drove the initial pre-market optimism that saw the S&P futures up more than 1% in pre-market trading before the sellers returned for a reality check?

March's CPI release by the Bureau of Labor Statistics or BLS showed that headline inflation had moderated further to a below-consensus 5% YoY, down from last month's 6% uptick.

However, core inflation remains high, as seen by the 5.6% YoY increase relative to February's 5.5% growth. Despite that, the market cheered initially, as it saw a consistent decline in the headline metric, corroborating a downtrend in inflation rates since June 2022's highs.

But, sellers returned to take profit, including hedgers who were likely covering their positions in anticipation of a worse release. Buyers caught up in the early optimism should have seen it coming. Why?

Market operators have likely anticipated a better-than-expected release since the SPY bottomed out in mid-March as the banking crisis peaked.

Therefore, the current levels (against a critical resistance zone) represent a solid opportunity to cut exposure, as underlying sector rotation could soon occur, with risk/reward fairly balanced, leaning to the downside in the near term.

Despite that, we don't expect a re-test of the SPY's October 2022 lows. The underlying breadth of risk-on plays, such as technology (XLK) and the Nasdaq (QQQ), has already climbed well above levels, inconsistent with a continuation of bear market behavior.

Investors considering adding exposure to the SPY are urged to be tactical, as we believe overheated sectors could see a rotation to undervalued ones, which could mitigate the potential upside at the current levels.

Why?

SPY sector weightings. Data source: S&P Cap IQ.

As a reminder, the tech sector accounts for about 26% of the SPY's weighting. Therefore, anticipating the price action of tech and its relative valuation will likely be critical to assess the SPY's directional bias.

We assessed that the valuation dislocation of the XLK against its 10Y average has normalized. It last traded at a normalized P/E of 24.3x, in line with its 10Y average of 25.4x. So, while it's not expensive, it's also no longer that cheap.

Moreover, XLK/SPY's long-term price action could stall at the current levels, even though we are still short of a definitive bull trap. Despite that, caution is warranted, suggesting investors should not expect XLK to drive SPY's near-term momentum.

However, we gleaned opportunities in sectors such as XLV and XLF. The XLF is particularly attractive, suggesting that investors should find the opportunity for alpha after sellers went out through a stampede in March.

XLY and XLC remain well-battered as they continue to trade well below their long-term moving averages. Despite that, their near-term recovery momentum has seemed to stall after a remarkable turnaround since the start of 2023.

Takeaway

After a remarkable U-turn from its March lows, the SPY has reached the critical resistance zone again. Despite a better-than-expected headline CPI metric, the initial euphoria quickly ended as sellers returned to cut exposure.

With that in mind, we expect the SPY's near-term bias to continue facing resistance, with a pullback looking increasingly likely. However, we don't expect a return to a bear market, so investors with exposure can consider holding out through the volatility.

Investors looking to add more positions should be tactical and consider sectors within the SPDR® S&P 500 ETF Trust that offer a more favorable reward/risk upside.

Rating: Hold (Reiterated).

Important note: Investors are reminded to do their own due diligence and not rely on the information provided as financial advice. The rating is also not intended to time a specific entry/exit at the point of writing unless otherwise specified.

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