Jump Around! Jump, Jump
Several factors worked together to lead to the sell-off. While the selling may not be over, to us this looks more like a positioning reset than a full scale collapse. Let's dig in...
There was a lot of blame for the past week’s sell-off pointed at the unwind of the Japanese Yen carry trade.
As a reminder, the Bank of Japan surprised the market by increasing interest rates 0.25% a week ago (July 31) - its second rate hike this year.
We wrote about Yen carry trade four months ago as a market driver here and before that here when we gave credit to the “carry trade” as a support for global liquidity and a tailwind for equities.
While we believe the unwind of the Yen carry trade was one catalyst for the move lower over the past few days, in any sell-off, there are generally several factors that conspire to move markets lower.
Here are some of the factors that we have considered:
The S&P 500 and Nasdaq 100 both hit their respective 1.618 Fibonacci extension levels of their January 2022 to October 2022 sell-offs.
These were the price objectives that we had seen as likely (see here and chart 1 here) and the Nasdaq 100 (chart 1 here and here). (I know this seems crazy, but somehow it works and needs to be considered).
Recession risk.
Last Friday’s employment report seemed (I will describe this in Chart 3 below) to trigger the Sahm rule which essentially shows that increases in unemployment (similar to the one reported last Friday) are consistent with recessions.
We have written about the two parallel worlds of the “real economy” and the equity market (here) - maybe we are seeing a convergence.
Is the Fed behind the curve (again)?
After last week’s Fed announcement where Powell made no move to ease the Fed Funds rate, investors fear that the economy is slowing quickly and the Fed’s September meeting feels a long way off.
Berkshire Hathaway reported over the weekend that they had sold half of its Apple position and now sits on its highest amount of cash ever.
Based on valuation (chart 4 here and here), we have characterized the equity market as “fragile” for some time. While we’ve been careful to to stay invested without being overly cautious, these “stairs up and elevator down” type moves can happen in “fragile” markets.
Earnings and earnings growth.
This is subtle, but it has been a theme of ours - while Q2 earnings season has been strong, several companies are (once again) reducing near-term future earnings expectations and adding to long-term projections. We have characterized this as “cut and roll” (see chart 3 here and here).
We have asked whether investors would begin to question AI spending? (here and here). Clearly, with the sell-off in the Magnificent 7, they have.
There are likely other factors, but this is our list for now.
Finally, as we have been saying for some time (see the introduction here):
While our S&P 500 target is 5500, it is possible in a blow-off top type scenario that the S&P 500 could move to 5600 or even 5800.
That said, we are beginning to see possible cracks in the foundation of the market’s ascent that, in our view, could become more apparent either late this year or in early 2025.
Although it’s a fools errand to try to develop a 6, 12 and 18-month road map for the equity market, we see the possibility (10-15% likelihood) of a 30% sell-off that see the S&P 500 bottom around 4000-4200 in 2025 from a peak of 5500-5800 in 2024.
While we may have seen the near-term peak in US equities and the current sell-off may have further to go, we see the current period as a normal seasonal sell-off driven by a number of catalysts.
We think fear of a recession may calm down and this is unlikely the beginning of the 30% sell-off that we have considered.
We have used this period to cover some puts and put spreads, recalibrate our portfolios (a little more defensive, a little more value) and yesterday we sold some volatility given the spike in the volatility index.
1. The S&P 500 ETF: All Eyes on 525
Source: Trading View. Through year-to-date 2024.
The chart above shows the S&P 500 ETF (ticker: SPY).
Although we showed this last week (here), after the sell-off, this is critical to update.
Very simply, with yesterday’s move lower, the S&P 500 ETF fell below the April 1 high at 525.
This morning it has moved back up towards this level.
We think it will be hard for the ETF to climb back meaningfully over this level (it could go as high as 528 in our view) on its first try.
We believe there is a high likelihood that there will be a move down to the 200-day moving average (curved red line) which is currently at 500 or back to the April 19 low at 495.
(This is not a recommendation to buy or sell any security and is not investment advice. Please do your own research and due diligence).
2. The Equal Weight Nasdaq 100: the Struggle is Real
Source: Trading View. Through year-to-date 2024.
The chart above shows the Equal Weight Nasdaq 100 ETF (ticker: QQEW).
There are several challenging characteristics about this chart:
What appeared to be a move up to a new, higher range on July 17, was in fact a “fake out” rather than a “break out.” The reversal has been violent.
The average Nasdaq 100 stock is now below its November 2021 peak (2nd to top blue horizontal line) and its 200-day moving average (red curved line).
Finally, the Equal Weight Nasdaq 100 ETF is down year to date (below the dashed light blue line).
What does all of this mean?
We think that the climb back higher will be a difficult one.
First, we see surpassing the 200-day moving average from below as a significant hurdle.
Once this level is surpassed, we see the December 31, 2023 and November 2021 levels as challenging barriers.
What this says to us is that after the “blow-off” top and breadth expansion, the sell-off over the past week has applied a meaningful hit to the market that will require time and energy (new buying power) to overcome.
This is partially why we have recalibrated our portfolios towards more value oriented (non-Nasdaq 100) names.
(Past performance is not indicative of further results. This is not a recommendation to buy or sell any security and is not investment advice. Please do your own due diligence).
3. The Sahm Rule Signaled that a Recession is Here or Did It?
Source: Haver Analytics / Rosenberg Research. Through year-to-date 2024.
The chart above shows the year over year change in the US unemployment rate.
Over the weekend, after last Friday’s employment report - there was a lot written about the Sahm rule.
First, the Sahm rule states that when the three-month moving average of the U.S. unemployment rate is at least half a percentage point higher than the 12-month low, than the US is in a recession.
Based on last Friday’s data - the Sahm rule was triggered…or was it?
The Sahm rule has never signaled a recession from unemployment levels as low as they currently are.
Furthermore, the increase in unemployment was caused by a rise in labor force participation rate not from higher layoffs.
Finally, the Sahm rule was technically NOT triggered.
Unrounded, the three-month moving average currently is 0.49337% above the 12-month low, just below the 0.5% threshold.
The 0.53% that many have referenced as a breach of the 0.5% barrier is based on rounding all the past unemployment rates to one decimal point.
According to Claudia Sahm, the first person to identify the relationship, “We are not in a recession now — contrary the historical signal from the Sahm rule — but the momentum is in that direction. A recession is not inevitable and there is substantial scope to reduce interest rates.”
(Past performance is not indicative of future results. This is not a recommendation to buy or sell any security and is not investment advice. Please do your own due diligence).
4. When is a Good Time to Sell?
Source: Wall Street Journal. Through year-to-date 2024.
The chart above shows the median 1-year return based on selling after big daily S&P 500 rises and falls (+/-3%) and after big monthly falls (-10%).
Basically, what this chart shows is that it doesn’t make sense for a long-term investor (1-year +) to sell after a big 1-day or 1-month drop.
However, what does add value (over “buy and hold”) is to sell after a large 1-day gain.
While we employ certain signals that might run counter to this, I thought it was important to share this data as I haven’t seen anything like it before.
(Past performance is not indicative of future results. This is not a recommendation to buy or sell any security and is not investment advice. Please do your own due diligence).
5. Perhaps Random, but Bullish
Source: Carson Investment Research / Ryan Detrick. Through year-to-date 2024.
We have continued to highlight the difference in what we see as a questionable fundamental backdrop - aggressive earnings expectations, elevated valuation multiples and questionable economic growth - and a positive technical story as we think it’s critical to keep an open mind.
As a reminder, the questionable fundamental backdrop has existed for the entire 48% climb from the October 2022 low.
Throughout 2023, many including me questioned the rally in the S&P 500 based on fundamentals while the technicians were “right.”
Furthermore, I was appalled watching one former Chief Economist declaring victory in the press yesterday after calling for a recession for the past year +.
Timing is critical in this industry and we are not here to be academically correct, we are here to make excellent risk adjusted returns. A recession call a year ago that might be right now is useless.
With that in mind, I present the chart above that shows that since 1950, after a 1% or more drop on a consecutive Thursday, Friday, and Monday, three months later, the S&P 500 has been higher 90% of the time and up nearly 10% on average.
One year later, the index has been up 18 of 21 times and up 22.5% on average.
Like the title of the chart says, random, but bullish.
(Past performance is not indicative of future results. This is not a recommendation to buy or sell any security, please do your own research).