Stocks hug the uptrend
As stated previously in “The Cobra Effect,” we noticed that the market remained confined to its consolidation channel.
“Unfortunately, the market failed to maintain its breakout which keeps it within the defined trading range. The market has maintained its bullish upward support trendline, which keeps the market’s “bullish bias” intact for now. “
This has remained the case again this week and keeps our allocation models mostly in abeyance for now.
While the market was unable to break past recent July highs, support remains on the uptrend line upward. With the short term “Buy signals” back in play, the bias for now is on the rise. However, as we have discussed over the past couple of weeks, July has retained its historic strength trends. With much of the S&P 500 earnings season behind us, we believe weakening economic data will begin to weigh on sentiment in August and September.
That’s why we’re keeping our hedges in place for now.
The gold / dollar battle
Speaking of hedging, we started building a long dollar position in the portfolios last week. There are several reasons for this:
- When the financial media discuss the falling dollar, it’s usually a good contrarian signal.
- The dollar has recently had a negative correlation with stocks, bonds, gold, commodities, etc.
- The rising exuberance of gold also acts as a reliable countercurrent indicator of the dollar.
- The dollar is currently 3 standard deviations below 200 dma which is historically a strong buy signal for a countertrend rally.
Since our portfolios are currently weighted in stocks, bonds and gold, we need to start hedging this risk with an uncorrelated asset. We also reduced some of our holdings alongside the addition of dollar hedging.
Our friends at Sentiment Trader also took up the same idea and published the following charts in support of our thesis. As noted, hedge fund exposure to the dollar has reached more bearish extremes.
As stated earlier, the dollar has a non-corollary relationship with gold. Anytime there is an extremely negative positioning of the dollar, forward returns are negative every period.
The key thing to note here is that the opportunity usually exists as end points. When stocks, gold and bonds exceed normal limits (200 dma), reversals tend to occur. The only question is the timing.
However, that said, the disconnect between the economy and the market remains a puzzle.
The GDP crash
On Friday we got the first official GDP estimate for the second quarter. In many ways, it was as bad as we had feared. As the chart below shows, the impression of an inflation-adjusted drop of almost 38% was staggering.
However, the “Return to economic normality” faces immense challenges. High unemployment rates, suppressed wages and high debt levels make “V-shaped” recovery unlikely. Nonetheless, current estimates for the third quarter forward suggest unprecedented rates of GDP growth.
This is where the « math » becomes problematic. A 38% draw in the second trimester requires a recovery of around 67% to return to balance. In the more optimistic recovery scenario detailed above, three-quarters of the record recovery rates still leave the economy in deep recession.
Even if the economy hits high recovery rates, it will not change the recession. The resulting 2.7% economic deficit will remain one of the deepest in history. While we welcome such a recovery, it is not enough to support larger jobs, wage growth or corporate profits.
A whole new (lower) trend
Here is the question missed by the majority of mainstream economists.
Before “Financial crisis,“The economy had a linear real GDP growth trend of 3.2%. After the 2008 recession, the growth rate fell to the exponential growth trend of around 2.2%. Instead of reducing debt problems, unproductive debt and indebtedness have increased.
the “COVID-19[FEMALE”[FEMININE » The crisis has led to a surge in debt to new heights. This will cause economic growth to lag 1.5% or less. As discussed previously, While the stock market may rise due to the Fed’s massive liquidity, only the richest 10% of the population holding 88% of the market will benefit. In the future, the economic bifurcation will widen to the point that 5% of the population owns almost all of it.
“This is not economic prosperity. It is a distortion of the economy. “
Any hat, no cattle
Above all, these are all extremely optimistic assumptions based on massive interventions by the federal government. While the economic downturn has been terrible, without the government’s massive stimulus injections, it would have been much worse.
The chart below shows the annual percentage change in federal spending and the growth rate of GDP minus Fed spending. Essentially, there was ZERO economic growth, excluding federal spending.
However, this is also why the stock market has performed so well.
The problem is the government’s ability to continue spending at increasing rates to support economic growth and markets.
As they say in Texas, the current rally was “All hat and no cattle. “
This is the greatest risk for bulls.
Last week we spoke with our RIAPro subscribers the dangers of chasing the markets, which have deviated considerably from their long-term means. The risk, of course, is that the markets, without exception, always revert to the mean. The only question is “Schedule”of the event.
This was a point recently discussed by Sarah Ponczek et Michael Regan chez Advisor Perspectives :
“People who buy bubble assets will make money until they don’t. If they don’t have a clue of what it will take for me to say, ‘OK enough already, I’m going out’, then they’re doomed to ride the roller coaster over and down. So, without selling discipline, buying bubble assets is insanely stupid.“- Rob Arnott, Research Affiliates
As we mentioned earlier in this letter, you cannot have a stock market that remains indefinitely detached from the fundamentals.
Reversals happen quickly
Above all, throughout history, it is not the fundamentals that are catching up with the market, but the opposite. The only question is to know what are the causes of this reversion?
Unfortunately, we do not and will not know what the catalyst will be. It won’t be COVID, bad economic data, or even low income. All these issues have been taken into account in the market and “Streamlined” by investors using the profits three years later.
While this is also incredibly stupid, investors will get away with it until an exogenous and unexpected event surprises the market. When that happens, as it did in March, it will take investors by surprise and the damage will be just as great.
There are a huge number of things that can go wrong in the months to come. This is particularly the case with soaring stocks against a depressed economy. As investors cling to ” hope “ that the Fed has everything under control, there is more than a small chance that it will not.
Either way, there is a truth about stocks and the economy.
“Stocks are NOT the economy. But the economy is a reflection of what sustains rising asset prices – corporate profits. “
That is why we continue to manage risks, adjust exposures and hedge accordingly.
Is this “Incredibly stupid” chase stocks here? Probably. But as Keynes once joked, “Markets can stay irrational longer than you can stay solvent. “
We understand the risk we take in this market and we apply risk management discipline. Or rather, as Rob Arnott suggests, a rigorous “Sell the discipline. “
Will he exempt us from any risk of a fall in portfolios?
But it will certainly reduce the risk to our capital more than not having any at all.
Manage in the unknown
As noted above, we are heading for two of the weakest market months of the year. It comes at a time when Congress is fighting for the next relief bill, the Federal Reserve is slowing weekly bond purchases, and the economic recovery is weakening. There is also the risk of a presidential election going completely wrong.
With the market currently extended, overbought and too bullish, we suggest the following actions to manage the portfolios over the next two months.
- Reassess the overall portfolio exposures. We will first seek to reduce overall equity allocations.
- Use rallies to raise funds as needed. (Cash is a risk-free portfolio hedge).
- Review all positions (Sell Losers / Cut Winners).
- Look for opportunities in other markets (the dollar is extremely oversold).
- Add covers to portfolios.
- Opportunistic trade (there are always rotations that we can take advantage of).
- Significantly tighten stop losses. (We previously gave the stop loss some wiggle room due to the significant oversold conditions in March. This is no longer the case).
The risk of ignoring the risk
There remains a continued bullish bias that continues to support the market in the short term. Bull markets rely on “Momentum” are very difficult to kill. Warning signs may last longer than logic predicts. Risk arises when investors start to ” discount “warnings and assume they are wrong.
It is usually around then that the inevitable correction occurs. This is the inherent risk of ignoring the risk.
In reality, there is little to lose by paying attention “Risk. “
If the warning signs prove to be incorrect, it is a straightforward process to remove the hedges and reassign them to equity risk accordingly.
However, if these warning signs materialize, a more conservative stance in portfolios will protect capital in the short term. A reduction in volatility allows a logical approach to make further adjustments as the correction becomes more apparent. (The goal is not to end up in a “panic selling” situation).
It also allows you to track “Golden rule of investment:”
“Buy low and sell high. “
So, now you know why we are looking for a “Salable rally. “
Editor’s Note: The bullet points for this article were chosen by the editors of Seeking Alpha.