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Will Inflation Be the Ruin Of The S&P?

Weekly Index Analysis

The S&P500 is looking like a sea of red currently as we await the US CPI data, which will give traders and investors a better idea of what the Federal Reserve may do, in terms of controlling the expected rise in inflation for the USA.

As the name suggests, there are 500 traded stocks within the index. The S&P 500 Index, or the Standard & Poor's 500 Index, is a market-capitalization-weighted index and benchmark for analysing the US large-cap stocks. It also gives traders and investors a good sense of the general sentiment of the equities and futures markets.

The company weighting is derived from the simple equation of Company Market Cap / Total of all Market Caps. With the top 5 companies in the S&P500 technology-heavy. In market-weighted order, they are Apple Inc, Microsoft Corp, Inc, Facebook Inc, and Alphabet (Google), also known as FAAMG. The ‘Oracle of Omaha’ Warren Buffett and his company Berkshire Hathaway Inc, lead JP Morgan Chase & Co, Tesla and Johnson and Johnson to make up the 10 top companies.

The S&P500 companies range across the broad spectrum of industries which include, Healthcare, Restaurants, Utilities, Industrials and Energy. But the tech heavyweights represent 21% of the S&P 500 index, well above the 14% average share that the top 5 stocks typically command and exceeded only by the 25% spike reached during 2020. The 5 leading companies have returned 9% YTD vs. 12% for the index, showing how reliant the indices elevated price is on the 5 biggest companies doing well. These companies benefitted from the stay-at-home nature of 2020 and during the pandemic, their businesses actually grew sales whereas most of the other components didn’t. They have also benefited from low-interest rates as this supports their premium valuations.

As we leave the most recent US earnings season behind us it should be noted that 57% of S&P 500 firms beat consensus sales estimates, which is a great rebound considering the ongoing supply chains and pandemic related disruptions. The FAAMG reported growth of 8% above market consensus and with that, year on year growth of 41%.

No investment goes up in a straight line forever and the 14-month bull run may not be at an end yet, but there are signs of fragility due to inflation expectations and also a sense of things may have run too far too quickly. The sentiment of retail traders to try and short the highs and be the one that called the top is pure ego, and having witnessed the rebound from 2009’s Great Financial Crash and how by 2012 traders were trying to short what turned out to be the longest, most hated bull run ever up until March 2020, I wouldn’t want to be the one to say the top is in.

Looking at the charts of the top 5 companies there is a mix of price action going on.

APPL is currently trading under the 2021 opening price. Looking at the most recent weekly significant lows and highs, it becomes obvious that the year’s opening price when tested proved to be too much resistance and now it looks more likely that traders come down to test the 119.80 swing low. If it were to be in a larger correction mode, the 50% pullback from the 2020 pandemic low to All-Time Highs (ATH) is just under the $100 and back towards the stock split price action from last summer. For the bulls to feel easier the price action needs to be trading above the 2021 opening price of 133.30 and then for a run on the ATH’s.

MSFT is still technically in a bull trending move, and at these price levels, the weekly close above the rising trend line is encouraging. There is a lot of structure left behind since the start of the impulsive move, so there are many opportunities to look for previous resistance to act as support. The first being the February 2021 swing high at around 245.90.

As a proxy to day trade in the S&P500, I often use APPL and MSFT to give me direction bias, as these two can move the whole market when they trade in line with each other.

AMZN has not traded so well this last couple of quarters, with a poke above the 2020 trading range before coming back in to test the rising trend line. A break lower than the marked-up 2020 trading range low would be a significant change in momentum.

FB is still making weekly higher high and higher low closes and above a very impulsive rising trend line. The breakout level from the end of March 2021 at around 295.00 would be a great test to see if buyers still remain interested and overall, the price action is $40-$50 above the years opening price.

GOOG is the current outlier with price action racing to the upside. If this were the top in the S&P500 and these behemoths were to tumble back down to pre-pandemic prices, the GOOG stock would have to retrace 50% of its price action to get back to the 2021 opening price. Something that would only be achievable with a black swan event or a prolonged market disruption. Obviously having just come out of a global pandemic, I am not suggesting that the 50% drop is impossible, just very unlikely. There is a nice balance area that will have traders and investors attention and that coincides with the 23.6% Fibonacci retracement level around 2092.00 – 2040.00 on the weekly chart. If the GOOG price were to fall back to that zone, the chances it is there would be the rising trend line as supporting confluence too.

Themes to watch out for which may have an accelerating effect on the downside of the FAAMG stocks. 1) The proposed tax reform plans by President Biden. 2) Interest rate hike cycle. 3) Government intervention and regulation.

President Biden has more than once indicated that he is looking to increase corporate capital gains tax, which analysts estimate would hit the FAAMG companies with a 9% decrease in earnings. Also, investors in the index could become subject to higher capital gains rates and would look to possibly book profit and move into other assets/securities to protect their net wealth.

Recently a lot has been talked about around the steepening yield curves and with the nominal 10-year Treasury yield rising to 1.6%, investors in FAAMG would still feel there is a long way to go before they move their allocation from the higher-yielding equities to fixed income. A rate hike cycle to fend off an overheating market may be enough to force these investors hands though. The Fed has made it clear that under their new mandate they are preparing to let the economy overheat until the recovery is felt by the broadest possible range of people. They will tolerate a period of above-target inflation and will need evidence of “substantial further progress” before they change policy.

Stricter regulation and tighter antitrust enforcement and possible breakups due to monopolisation concerns would be a severe blow to the tech industry and its investors. In the US Presidential election, the rhetoric was around the big tech firms having too much sway and political influence. President Biden and his team have all indicated they are not going to follow in the footsteps of President Obama who was very close with Silicon Valley. The Biden administration has both supported Amazon workers and openly criticised Amazon for not paying enough tax. Google has an antitrust lawsuit against them from the US Dept. of Justice, plus there is a review of section 230, which has exempted technology companies from any liability for the content their users share on them.

In the last 14 months, the S&P500 has nearly risen 200 points, effectively doubling the price from prices last seen in 2016 and the 2020 March COVID-19 pandemic lows. If the worst-case scenario were to occur, where Regulation, Tax and Interest Rates all came at the markets in a joint effort and the fiscal support from the Biden administration were to be removed, we may get a significant pullback assuming there are no actual black swan events.

A 50% retracement would have price trading around 3255.50 and the 2019 highs, which were tested on the breakout last October. A 10% pullback from ATH’s would have the S&P500 trade below the 4000 again to around 3800 and a 20% correction would see price test the 3485 and 38.2% fib retracement, which would be a test of a decent balance zone.

On the daily chart, the 50-period exponential moving average (ema) has offered decent support before and looks likely to be tested again in the current corrective price action. The 200 ema, is quite a way down around 3740, so maybe confluent with a 20% correction as stated before.

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