Updated September 18, 2023
Raymond Micaletti, Ph.D.
The broad market ended the week down half a percent in a data-packed week that culminated with the monthly and quarterly options expirations.
For the most part the inflation and economic data came in higher than expected. Rates and the dollar both rose (the latter for the ninth week in a row). Accordingly, one might have expected equities to have a more bearish reaction after the CPI, PPI, and retail sales reports Wednesday and Thursday, but instead equities rallied.
On Friday, however, another batch of firm economic data (most likely coupled with the imminent options expiration) sent equities sharply lower.
Despite the hot inflation and firm economic data, the implied probability of another Fed rate hike decreased during the week, making this week's FOMC meeting all the more pivotal.
The Wall Street Journal's Nick Timiraos was out last week saying the Fed would not be raising rates this week because it doesn't want to overtighten. Rather, it wants to buy time to see the effects of its past hikes.
But that doesn't explain why November's probability of a hike diminished in the face of robust economic data.
One explanation might be that a hard (or harder) landing is in the cards. Jared Dillian, former Lehman trader and author of The Daily Dirtnap, writes "I'm the qualitative guy, not the quantitative guy, and I've been spending the last two months collecting stories and anecdotes on how the economy is croaking. I have 4,000+ subscribers to TDD, from a range of industries, and they're all saying the same thing: look out below."
His thesis is that rates, the dollar, and stocks will all fall, while gold rises.
Interestingly enough, last week's changes in investor positioning seem to align with his thesis. Equity positioning turned more bearish, dollar positioning remained bearish, and gold positioning became less bearish. To wit:
Equities: Composite equity relative sentiment fell from 65% to just under 50%, its lowest level since mid-June 2022. Moreover, it has high potential to fall to the mid-30s next week without a setback in commodities prices. Cross-asset positioning for equities has shifted to neutral from bullish on account of bond positioning no longer being bullish enough to overcome the bearish positioning in equities.
Dollar: The Smart Money bought the dollar on a relative basis last week, but not nearly enough to flip dollar relative sentiment bullish (it remains bearish). Consequently, it’s reasonable to believe the recent dollar rally is a countertrend correction rather than a new bull phase.
Gold: Institutions resumed their aggressive short-covering in both gold and silver last week. While the short-covering was enough to shift silver to a neutral stance (from bearish), it wasn't enough to move gold out of bearish relative sentiment territory. That said, gold tends to do well when equity relative sentiment falls below 50%, which just happened. So, we may see gold perform a bit better than it has in recent weeks.
The Bull Case
The bull case for equities has lost some luster after last week, as relative sentiment is no longer bullish, tech might not be leading anymore, and retail sentiment is on the rise. Which leaves:
Momentum: We are 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
Bond Volatility: Is at its lowest level in seven months. Lower bond volatility generally correlates with lower equity volatility and rising equity prices.
September: Though September has been unconditionally the worst month of the year for the stock market, when the market has been up strongly through July or the VIX has been below 14 in August (both of which occurred this year), September has tended to be a good month for the market
The Bear Case
The bear case for equities expands:
Valuations: 10-year expected annualized (nominal) U.S. equity returns ended the week at 3.2%, while the 10-year U.S. Treasury yield closed at 4.33%. Thus, holding 10-year Treasuries over the next decade is likely to produce higher returns than holding U.S. equities.
Fiscal dominance: The strength of recent economic data appears to bolster the case that raising interest rates when debt is high relative to GDP leads to further growth via increased interest payments flowing into the economy. Higher interest payments and growth lead to a feedback loop that keeps upwards pressure on inflation and rates, which then lead to more interest payments, and so on and so forth until the bond market malfunctions.
Equity Positioning: Institutions wiped out two weeks of equity purchases with strong selling last week. As a result, the differential between their positioning (bearish) and speculators' positioning (bullish) has reached a level that in the recent past has coincided with major equity selloffs (Q4 2018, March 2020, H1 2022).
Reemergence of Inflation? Oil is up 33% in the third quarter and the oil-supply deficit is set to widen to 1.2 million barrels per day by the end of the year.
Options Dealers Short VIX: Options dealers are substantially short VIX calls. As The Market Ear says, "Things could easily get a bit 'fluid' should VIX move higher quickly...."
0DTE Options ETF Launch: "The strategy's objective is to generate outsized monthly distributions by selling option premium on a daily basis. The fund uses daily options to realize rapid time decay by selling in the month puts with 0DTE." Again quoting The Market Ear, "You don't see this at market lows...."
The Calm Before the Storm? The S&P 500 has gone 99 trading days without a 1.5% loss, something that has happened only 5 times in 15 years (although three of those five times the day-count continued higher into the low-to-mid 100s).
In a similar vein, Nick Colas of DataTrek writes: “Corporate bond spreads remain very tight, which says that the market remains very optimistic about future earnings. In the meantime, real Treasury yields remain near +10-year highs and look like they want to go higher. Against that backdrop, equity market volatility remains low. Stitch together those market narratives, and the near-term picture feels cloudy. Not stormy, necessarily … But certainly cloudy.”
Lastly, JPMorgan CEO, Jamie Dimon, said this week that the U.S. government has to sell $7 trillion in bonds over the next year at the same time that central banks and countries such as China and Japan will also be selling U.S. Treasuries. His conclusion? "...I’m on the cautious side on all that stuff…including credit spreads. I would not be a buyer of Treasuries at 4.2%, nor would I be a buyer of credit spreads at these spread levels."
If credit spreads were to widen that would almost certainly be accompanied by lower equity prices.
Things had been looking up for equities in recent weeks. Momentum was positive, relative sentiment was solidly bullish, retail investors got bearish during the late-summer selloff, etc. The August dip appeared to have run its course.
Now, however, the landscape appears to have shifted a bit. Relative sentiment is no longer bullish; investors appear to be positioning for a rise in gold; what seemed to be a bear flag in the ratio chart of the S&P 500 to the Nasdaq 100 now looks like it may have morphed into an inverse head-and-shoulders (which suggests lower equity prices, with tech leading on the downside).
The market does not appear to be worried about another rate hike despite hot inflation data and oil prices up 33% in the third quarter. That's gotta be telling us something.
And not only is equity positioning no longer bullish, the differential in positioning between institutions and speculators is at a level that has coincided with several major market selloffs on past occasions.
As a result, we have a much more cautious outlook with respect to equities in the near-term. We think the odds of the market experiencing another leg lower in its recent correction have increased.
If no dip is forthcoming and institutions continue to sell into the rally, that would suggest any gains from here would eventually be given back.
If we fall and institutions buy into the dip, that would suggest we get a year-end rally.
However, if we fall and institutions do not buy into the dip, then, in the words of Jared Dillian, "Look out below."
Allio Portfolio Updates
No change to Allio’s core or tactical portfolios last week.
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