Updated August 7, 2023
Raymond Micaletti, Ph.D.
We witnessed another eventful week in markets last week on the heels of the previous week’s data deluge. Equities tumbled in the wake of Fitch’s U.S. debt downgrade, mixed mega-cap tech earnings, and a disappointing jobs report.
Broad U.S. equities fell four straight days from Tuesday to Friday and closed the week down 2%. The Nasdaq closed down 3%.
The dollar rose a modest 0.4%, while gold fell nearly 1%. Commodities were flat despite oil’s 3% rise. Thirty-year U.S. Treasury yields blew out, rising as much as 30 basis points (bps) from last week’s close before ending the week 18 bps higher.
The headline news last week was Fitch’s downgrade of U.S. debt on concerns about “US governance, fiscal responsibility, and political divisiveness.” The broad consensus seemed to be that the downgrade wasn’t that big of a deal. Few investors will be forced to sell Treasuries because of it. Nonetheless, yields rose sharply and equities, after months of relentless rallying, used the downgrade as an excuse to take profits.
On Thursday, both Amazon and Apple released earnings after the bell. Amazon wildly surpassed expectations and saw its stock rise by as much as 11.5% over its Thursday close, before settling 8.3% higher.
Apple, on the other hand, did not impress investors and saw its revenue decline for the fourth quarter in a row. It was punished on Friday, falling 4.8% (which left its year-to-date return at a still healthy 40%).
On Friday the non-farm payrolls report came in slightly below expectations, leaving the market somewhat confused as to how to react. Eventually, after tracing out a textbook megaphone pattern, U.S. equity markets finished the day down moderately.
Next week we’ll get the CPI and PPI on Thursday and Friday, respectively. Street forecasts are for both core and headline CPI to have increased by 0.2% in July.
In contrast, the Cleveland Fed’s inflation nowcasting has July core and headline CPI at 0.4%–a fairly big difference.
As of Friday, the market was forecasting the Fed was done with its rate hikes for this cycle. But if inflation comes in hot this week, that forecasting could change for the worse and we would likely see continued market volatility (in both equities and bonds).
On the investor-positioning front, we observed several interesting developments last week.
The smart money continued to sell the dollar. Dollar relative sentiment has now moved noticeably away from its bullish threshold and is back comfortably in bearish territory. This suggests, at best, that the dollar might find it hard to get any traction to the upside, and at worst, it could continue its 10-months slide. A weakening dollar would likely be favorable for commodities and commodities-related equities, and potentially the majority of risk assets.
Investor positioning in commodities will turn bullish for equities this coming week. Recall that relative sentiment in growth- and inflation-related assets turned bearish for equities on July 28, just in time for a 2%-3% decline in markets. But this past week the smart money once again positioned themselves in such a way that growth-and-inflation-related relative sentiment will flip bullish at week-end.
The smart money continued to buy gold, silver, and oil, but their relative positioning in those assets is still either neutral (gold, oil) or bearish (silver).
The Bull Case
The bull case has two primary pillars:
Momentum: We are still well within the downstream windows of seemingly dozens of positive momentum triggers from the past several months, in addition to the multiple breadth thrusts seen earlier this year.
Relative sentiment, which in recent weeks has dipped into the mid-50s (a marginally bullish reading), will likely jump to the high-70s to mid-80s next week. Note that this jump is happening despite the nascent equity selloff being somewhat limited so far. Thus, we could easily find many reasons to qualify and downplay this jump as being “too early” to get back to being aggressive in equities.
But the same downplaying could have been done in October, when relative sentiment was at 85% while the world was ending. It also could have been done on March 10, the day relative sentiment hit 100% despite Silicon Valley Bank collapsing that week and equities being in the midst of a 9% drawdown.
Historically, the combination of positive momentum and positive relative sentiment tends to see favorable forward returns (on the order of 15% annualized).
The Bear Case
The bear case is multifaceted:
Last week the expected risk premium for stocks relative to bonds over the next 10 years hit -200 bps annualized. This week it came back a bit, but is still at -170 bps. U.S. equities simply are not attractive investments for the long-term at these valuations.
Despite 80% of companies beating earnings estimates, earnings reactions have been negative, on average, regardless of whether a company beats, is inline, or misses. Moreover, full-year earnings estimates for 2023 and 2024 have not shifted upwards.
Long-term interest rates are threatening to push higher than their October highs. With the Bank of Japan loosening its yield curve control policy, Japanese investors now have a strong incentive to sell U.S. Treasuries and buy Japanese government bonds. This supply of U.S. Treasuries will augment the existing supply of Treasuries coming from the Fed’s quantitative tightening and the Treasury’s debt issuance to fund the ballooning deficits, and may keep upward pressure on yields, which in turn could create headwinds for equities.
Regardless of whether the market goes up, down, or sideways this month, CTAs will be forced to sell equities by their models. In a down tape over the next month, the amount of equities to be sold is nearly $300 billion.
Option dealers’ “gamma” will get more and more negative the lower the equity market goes, which will force those dealers to sell equities as the market moves lower–thereby reinforcing the selloff.
Goldman’s “flow guru,” Scott Rubner, said on Friday to “fade the green” (the market was up solidly in the late morning) as “the market technical flow-of-funds have seen a significant deterioration heading into the worst two week liquid period of the year.”
We think the market is vulnerable to a continued selloff in the near term, as its perceived invincibility has been dented and its recent rate of ascent was unsustainable.
As the market has continued to rise in recent weeks, it’s reasonable to believe that a lot of stop-loss orders accumulated a few percent below current levels. It would be par for the course for the market to take out those nearby stop-loss orders before stabilizing and resuming its uptrend.
And we do think it will stabilize and head higher over the intermediate term. The combination of positive momentum and bullish relative sentiment is a formidable one, one that tends to see the market drift higher at an above-average clip.
Thus, we would view the market becoming oversold in the next couple weeks as an opportunity to add to one’s equity exposure. The odds seem aligned for the market to threaten new all-time highs later this year, and the upcoming low when the current selloff runs its course might be the last interim low before new all-time highs.
Allio Portfolio Updates
No changes to Allio’s core or tactical portfolios last week.
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