“Markets in Turmoil”

The equity market correction continued during the past week, as a strong rally failed on Wednesday and confirmed the bearish price action. The market is starting to wake up to the fact that Federal Reserve rate cuts are not as bullish for stocks as once believed. When the Fed lowers interest rates following an extended period of restrictive policy, it usually does so as a response to weaker economic activity. Since a weaker economy precedes a decline in earnings growth, the market is hasty to discount the impact on multiples and EPS - thus lowering stock prices.

To add fuel to the fire, a 25 bps rate hike by the Bank of Japan last Wednesday catapulted the Yen almost +8% higher versus the US Dollar in just 4 trading sessions, putting immense pressure on the “carry trade” and forcing liquidations across various asset markets, including US stocks and crypto. At the time of this writing, S&P 500 futures are down -2.58%, Nasdaq futures are lower by -4.06%, Bitcoin is logging a -12.7% decline, while Ethereum is crashing by around -20%. The Nikkey has recorded a historic -12.4% drop overnight, erasing all of the gains in 2024.

Technically, last week ended on a somewhat resilient note, with a potential setup for a reflexive rally going into this week. SPY just held on to the pivot level near $533 (the 100-DMA provided support into the close on Friday), with potential upside to the 50-DMA near $543. However, a bounce does not appear to be in the cards when looking at the pre-market session this morning. If the market breaks $533 to the downside, there is potential for a larger pullback to $496 (and the 200-DMA) as the next logical levels of support.

The MACD signal is reasonably extended downward going back 2 years, while the Overbought / Oversold indicator reads 11/100 for SPY as of Friday’s close. The current drawdown of -5.66% has already eclipsed April’s pullback and now stands slightly over 1 standard deviation. Volatility has increased toward 2 standard deviations, as seen on the bottom graph.

All of this is to say that in the very short term, selling exhaustion appears to be near, especially as Monday’s session is not factored in to these calculations. Uber-bearish commentary and thin liquidity are driving the action right now, and the market is getting decently oversold.

According to our internal sentiment metric, there was still enough bullishness among investors last week as to not warrant any contrarian buying just yet. In other words, we currently don’t see any reliable counter-trend signal to trade at the moment, excepting any short-term intra-week rallies. The number of stocks which are oversold are not indicative of “panic”.

The WSJ article headline posted below is also reflective of this stance. To be sure, panic is coming.

However, that may change going forward, as leveraged traders and investors are starting to get wiped out. Unusual Whales reports that +200K accounts in the crypto space are down to $0.00 (or worse) as of this morning. During the last year, crypto investors have been acting as canaries in the coal mine for risk sentiment in traditional stock markets as well. While the dollar figure of losses is minuscule compared to the public equity market, the number of accounts is significant.

The main culprit of the market rout has been a slew of weak economic readings, especially a terrible employment report and a larger than expected drop in Manufacturing PMI. Specifically,

“The ISM Manufacturing PMI fell to 46.6 in July of 2024 from 48.5 in the previous month, firmly below market expectations of 48.8, reflecting the sharpest contraction in US factory activity since November 2023. It was the 20th decline in activity during the last 21 periods, underscoring the impact of high interest rates on goods demand […]”

-Institute for Supply Management

Most notably the coming yield curve un-inversion has investors spooked. There are many yield curves to track, but the 2-10 is the most common and has a good track record of closely aligning with recessionary periods. Notably, recessions (shaded areas) are dated by the National Bureau of Economic Research (NBER) which is always late in announcing a contraction. It may be the case that the recession has already started - and that is what the market is very concerned about.

The fact that the economy is slowing is not exactly surprising. The Fed itself has recognized that financial conditions were “restrictive” and have been for almost one year. With unemployment rising, wage growth declining and stimulus all but tapped out, live inflation readings (as measured by Truflation) have been trending ever lower in 2024.

The real issue going forward is going to be excessive dis-inflation - and it’s the reason some commentators suggest that the Fed is now “behind the ball”.

“The labor market cracks have given sudden urgency to concerns that the Fed has waited too long to begin cutting rates — and that it might be falling behind, allowing the job market to slow in a way that will be hard to stall or reverse.

They are absolutely behind the curve, and they need to catch up.

High Fed interest rates help to cool inflation by slowing demand. When it costs more to borrow to buy a house or expand a business, people make fewer big purchases and companies hire fewer workers. As economic activity pulls back, businesses struggle to raise prices as quickly, and inflation moderates.”

-Julia Coronado, MacroPolicy Perspectives

Finally, the Sahm Rule is also pointing to a recessionary environment ahead. Sahm Recession Indicator signals the start of a recession when the three-month moving average of the national unemployment rate (U3) rises by 0.50 percentage points or more relative to the minimum of the three-month averages from the previous 12 months. Given the last reading of 0.53, this indicator has also triggered.

The bond market is responding by collapsing yields, especially at the long end of the curve. Treasuries are already discounting weaker economic growth, earnings risk, elevated valuations, and a reversal of monetary support.

TLT has achieved a technical breakout and is now heavily overbought. Bonds have been the only place to hide during this downturn, as a negative correlation with equities has manifested due to recession fears. Previously, a somewhat positive correlation regime existed between stocks and bonds, as inflation was seen as high and persistent. This view is starting to unwind.

During uncertain times, it’s best to rely on our fundamental analysis work. While our base case scenario implies a $582 price target for SPY and >9% of upside - it is not the only scenario that we see. Using more pessimistic (realistic?) assumptions for company results yields a $540 price target which does not currently warrant any investment.

Ideally, we would like to see both of these price targets hold up by the end of the month when a quarterly re-analysis is due. In order to justify investing in SPY, we’d like to buy at a price which allows for correct compensation, no matter the scenario.

Currently, the correct compensation for holding stocks over bonds is around 8.2% of potential upside (risk-free rate of 4.2% + 4% ERP). In order for this minimal upside to be satisfied in both cases, SPY needs to be priced at $499 in order to warrant safe investment (-6.3% from last close). This also aligns with our technical analysis and a “retracement to the 200-DMA” scenario.

Our Trading Strategy

We are currently holding a couple of positions that have triggered stop-loss levels. Given the liquidity crunch and very high volatility readings, we would not be in a hurry to offload these just yet. As a consequence, we will be using rallies to sell into and reduce risk exposure as needed.

We are aiming to align with the Enterprise strategy, currently holding just 37% Equity Long exposure by the time this correction episode is over. While there is indeed no reason to panic, some measures need to be taken in order to preserve capital and hedge the possibility of even a mild recession.

At the moment, we have paused buying in our client accounts, choosing to only enter SELL orders into the book. Healthy exposure to treasuries has safeguarded our portfolio from a more sharp downturn - however it is unclear to what extent that hedging will work going forward. We will also cut commodity exposure, as these will suffer a downturn in the economic cycle.

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