Updated August 21, 2023
Raymond Micaletti, Ph.D.
The broad market fell for the third consecutive week last week and not modestly either—down 2.2%. Most other assets followed suit, with commodities, gold, and long-duration bonds all down greater than 1%.
In contrast, the dollar was up for the fifth consecutive week (a streak that began with the false breakdown after the mid-July CPI report).
The 10-year U.S. Treasury yield broke out to a 16-year high above 4.24%, which made equities (whose earnings yield is not much higher) look less attractive on a relative basis.
And from there, selling led to more selling as both CTAs and options dealers needed to sell increasing amounts of equities as the market moved lower.
What triggered the rise in bond yields? One possible explanation is China having to sell U.S. Treasuries in order to support its currency, which has weakened on account of the country’s ongoing economic problems (namely, household demand falling fast as the country’s real estate market collapses).
Amazingly, despite China’s rough patch, global oil demand has remained robust, keeping a floor under oil and other commodities, and applying additional upward pressure on interest rates.
In turn, the rise in rates has finally started to bite “long-duration” equities, namely, technology stocks, which, after a huge rally the first seven months of the year, have been hit the hardest in the recent selloff.
As investors, should we be concerned these trends will continue?
To put it bluntly, yes, we should be.
Well, for the past 13 months, the relative equity positioning between institutions and speculators has been either bullish or neutral for equities. That is, until last week.
On a few occasions over the past year, you may recall we mentioned that we didn’t think the market would top until the difference between the positioning z-scores of institutions and speculators reached at least -4 standard deviations.
This week that difference reached -3.75 standard deviations (institutions are 2 standard deviations bearish and speculators are 1.75 standard deviations bullish).
The difference in z-scores has reached this level or worse on 12 previous occasions since 1995. And the average forward performance of the market across those 12 instances has been subpar.
Whether the market moved up or down was generally hit-or-miss–50% percent of the time it moved higher and 50% of the time it moved lower. But the losses tended to be on the larger side, with notable instances occurring around:
The peak of the dotcom bubble in mid-1999
Two months prior to Lehman Brothers’ bankruptcy in 2008
Early in the March 2020 COVID selloff
At the peak of the market in 2021
As a result, it’s reasonable to believe the probability the market moves to new all-time highs has diminished somewhat (though it may still be substantial).
But before we throw in the towel on this year’s rally, it’s important to note that positioning in most other assets is still favorable for equities.
For example, the Smart Money maintains positions that suggest financial conditions will continue to ease.
Consequently, we may see a near-term tug-of-war between favorable positioning in liquidity-related assets and unfavorable positioning in equities.
This week we will get Nvidia earnings. You might recall that Nvidia’s prior earnings report on May 24–and particularly its revenue guidance for the current quarter (which was 50% above analysts’ estimates at the time)–was the catalyst that sent the Nasdaq on its feverish, multi-month AI-driven rally.
Thus, the market will no doubt be looking to see whether Nvidia delivers. If so, we would imagine equities find support and look to bounce. If not, things could conceivably get ugly for mega-cap tech stocks.
At the end of the week, we’ll get Jerome Powell’s Jackson Hole speech, which will likely set the market’s tone for September, the weakest month of the year.
The Fed has generally stayed away from jawboning the equity market lower this year and it’s reasonable to expect a similar policy this week.
And with that, let’s examine the bull and bear cases for the market.
The Bull Case
The bull case is looking a little thin these days and living off past glory:
Still downwind from several momentum triggers and breadth thrusts from earlier in the year–the windows over which they tend to act would take us into Q1/Q2 2024
Composite relative sentiment increased last week–despite the institutional selling of equities–on account of strong cross-asset relative sentiment and an easing in retail commodities sentiment. It now sits at a solidly bullish 87%, it’s highest reading since April
The current selloff may be viewed as a normal pullback after a huge rally into a seasonally weak period of the year (and thus no cause for panic just yet)
This week retail traders sold a big portion of the equities they bought in June and July and their 20-day flows have turned “solidly negative” (JPMorgan via The Market Ear)–that reset in sentiment may be the necessary catalyst for the market to take its next leg higher
The Bear Case
The bear case, in contrast, is formidable:
3- and 6-month T-bill yields are both greater than the S&P 500 earnings yield, and at their highest levels since 2001 (Goldman via The Market Ear)
Real rates are pushing 2%, a level not conducive to P/E expansion, and the expected equity risk premium is -165 basis points
CTAs have a good deal more equities to sell if the market continues lower
China’s ongoing malaise could continue to put upward pressure on interest rates as China sells U.S. Treasuries (alongside the Fed’s quantitative tightening and the Treasury’s general issuance) to defend its currency
According to Jefferies, companies have been guiding revenues higher at the lowest rate since 2015/2016, which may suggest a slowdown is on the horizon
The sharp selling by institutions last week and their cumulative bearish positioning relative to speculators has put us on high alert. While it could be nothing, similar bearish positioning has been observed near previous (and notable) market tops.
In recent weeks, our belief has been that the market would ultimately move higher because momentum was strong, equity relative sentiment was still bullish, and the positioning between institutions and speculators was neutral.
Now that the latter criterion has reached a bearish extreme, it opens up the possibility that we might have topped and that equities could move persistently lower from here. While we don’t have data on what institutions did Wednesday through Friday (we will get that information this upcoming week), the fact they sold a significant amount of equities as of last Tuesday when the market had already fallen the prior two weeks (albeit small) is not auspicious.
Despite that inauspiciousness, we still lean (though not as strongly as before) toward the view that equities will resume their uptrend.
While investors’ relative positioning in equities is a respectable indicator of the market’s future direction, how investors are positioned in other asset classes can augment that signal and right now cross-asset positioning remains solidly in favor of higher equities.
Throw in positive momentum and an oversold market and we give a modest edge to the market eventually stabilizing and resuming its uptrend.
Could we see more downside in the near-term? It’s certainly possible, if interest rates and the dollar keep marching higher.
But the fact that the Smart Money is getting more bearish on the dollar relative to retail traders and scooping up gold and silver on a relative basis suggests financial conditions may continue to ease, which should at least be beneficial for commodity-related equities, if not the entire market.
Let’s see how Nvidia’s earnings on Wednesday and Powell’s speech on Friday shape the landscape as we move into the market’s weakest month of the year.
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