Is the market crash over?

Last week, the market correction continued, as we thought it would. On Monday, a liquidation event occured due to the unwind of the “Yen Carry Trade”. To add a little context to this mini-crash, consider the following:

Yen carry traders own significantly leveraged volatile risk assets, including cryptocurrencies, small-cap stocks, mega-cap stocks, and the Japanese market. The strategy thrives as long as the Japanese Yen remains stable. If it appreciates markedly, it can trigger leverage-related liquidations (margin calls). Recently, the Yen has appreciated over 15%, leading Japanese banks to issue these margin calls. In response, hedge funds, pension funds, insurance companies, and other investors involved in the Yen carry trade are forced to either provide additional collateral or liquidate their leveraged positions. This forced selling has caused a downward spiral, further strengthening the Yen while driving down the prices of risk assets.

These kinds of events rarely devolve into more serious affairs, as they tend to be temporary in nature and happen on account of mechanical trading (momentary supply / demand imbalance). There is always an “unexpected catalyst” that triggers selling and penalizes investors’ complacency, but the core dynamic remains the same:

Leverage + Bullish Psychology + Momentum = “Mean Reverting Event”

The only question that requires answering now is “is this episode over?”.

From a technical volume standpoint, this particular event (the Yen Carry Trade) is over and properly discounted. After heavily spiking on Monday, transaction volume across exchanges (and accompanying volatility) is back to normal levels, signaling the pressure on prices has normalized.

We can safely assume that anyone who HAD to exit their positions have already done so by now. Goldman Sachs and JP Morgan noted that much of the pressure from the Yen carry trade has been resolved. According to Goldman, investors are net long the Yen as of this week, which implies that the carry trade has been primarily unwound.

Furthermore, hedge funds are now back to re-entering long positions, as they too are assuming that sellers have exhausted themselves.

The de-risking trend in large caps was well underway even before the volatility created by the Yen trade ever occured. As of this writing, the week-over-week return (Aug. 2 - Aug. 9) of SPY is 0.00%. In other words, had you been on vacation in the past week and never opened your portfolio, you wouldn’t think that the market did anything interesting in the interim.

Over the past month, however, the repricing of risk assets is notable, with all major indices well off their summer highs recorded in mid-July. More prolonged periods of correction do tend to have an outsized impact on investor’s psychology, as everyone suddenly becomes aware of “risk”. To navigate a correctionary process, we can follow the typical pattern and understand which stage we’re currently at:

1. An unexpected and unpredictable event that “no one saw coming” causes an imbalance of sellers versus buyers, momentarily depressing prices as forced liquidation occurs; ✅

2. A temporary “floor” is found, as willing buyers step in at substantially lower prices; ✅

3. The market bounces sharply, as buyers step in; ✅

4. The initial rally fails at resistance and prices revert and retest previous lows, as buyers’ conviction is put into question;

5. Buyers eventually regain control of the narrative and the final bottom is put into place.

We are currently at stage #4, as advancing from current levels becomes more problematic in the medium turn. The “easy money” from a technical bounce has already been made (stage #3). Now, the market must find “longer term investors”, with the necessary conviction to hold positions through another correction episode.

For SPY, the most likely resistance level is between $535 and $543 (M-Trend and 50-DMA). With the 20-DMA crossing below the 50-DMA at around $542, a formidable resistance level is formed just above Friday’s close. While equities may still be oversold enough for a further rally, we see upside as limited at this point and potential downside looming ahead of the elections in November.

Over the next couple of months, there are sufficient potential catalysts to spark a further decline. Most notably, the Fed’s Jackson Hole meeting could result in a hawkish surprise for the market, given that the probability of a 50bps rate cut is currently priced at 48.5%.

Nick Timiraos (from the Wall Street Journal) suggests that further data weakening is necessary to push the Fed from a 25bps to a 50bps cut in September. Normally, the ruling out of a 50bps cut would be seen as a net negative.

Seasonality suggests that the August - October period is typically weaker during election years, as many hedge funds are reluctant to take on significant volatility risk in this period. Therefore, a more cautious approach to portfolio management makes sense at the moment.

According to our internal sentiment gauge, there is still room for sentiment to deteriorate further, as investors are reasonably optimistic at this point. Over the course of last week, we’ve had conversations with our retail advisory clients who were asking for more risk exposure and “dip-buying” in their portfolios. “Greed” has not been entirely replaced by “Fear”, despite the current correction episode.

The bond market has recently exhibited a negative correlation to equities, in a very meaningful shift. We expect treasuries to consolidate in the next period, as the collapse in yields takes a pause. With more Fed easing priced in, the 2-10 yield curve is also close to un-inversion (a potential berish catalyst in and of itself).

For now, technicals look excellent on TLT in the medium and longer term. This is one asset class we are actively looking to buy on the dip.

Our Trading Strategy

The most logical path forward for the equity market consists of a retest of the 200-DMA, around the $500 price level on SPY. This coincides with a fundamentally sound entry point as well, according to our 1-year price targets (due to be refreshed at the end of this month).

While our systems are by no means a “crystal ball”, we can summarize possibilities and probabilities. Tomorrow’s portfolio rebalance for the Enterprise strategy will be key to our approach, since this model was specifically designed to provide guidance in these types of scenarios. So far, the market has “cracked”, but the correction episode appears normal. However, a deeper drawdown would also be normal and could present a better entry point. Consider that the 200-Daily Moving Average is an “average” because prices fluctuate both above and below it. We have not had a 200-DMA retracement in almost one year of trading, and this is below historical odds (on average, the S&P 500 might experience a retracement to the 200-DMA around 2 to 5 times per year).

We’ll cover specific portfolio actions in tomorrow’s article. For now, any investor can use the current rally to adjust portfolio positioning by:

1. Adjusting stop-loss levels

2. Taking profits in winning positions

3. Cutting losers short

4. Raising more cash than usual

We are not “running away for the hills” and holding 100% cash at the moment, and this is not the main message of our missive. We’ll simply be more patient than the “crowd” and let the market dictate our next move. If we’re wrong, it’s very easy to add risk exposure back to portfolios. Replacing lost capital is altogether harder to do.

Signal Sigma PRO members will be notified by Trade Alert of any live portfolio changes (if subscribed). If you’re not on this plan yet, you can get a free trial when you join our Society Forum. If you need any help with your trading strategy (or would like to implement one on your account), feel free to reach out!