Portfolio Trade Alert – June 27, 2022

Trade Alert For Equity & ETF Models OnlyCORRECTION

*** In the initial trade alert I stated we added 1% to XLE. That was incorrect as we initiated a 1% position of the portfolio in XOP. The trade was made correctly in the portfolio.

As we enter into the last week of the quarter, we are adding a smidge of trading exposure to portfolios ahead of the $30 billion portfolio rebalancing required by month-end. With many mutual fund managers underexposed equities, and the markets triggering a short-term MACD buy signal, there is some upside to 3900-4000 on the S&P 500 index.

As such, we are adding 5% equity in two trading index positions and increasing exposure to energy by 1% following the rather brutal sell-off recently. These are opportunistic trades that we will sell on a rally, or as needed to reduce equity exposure later on.

Equity Model

  • Buy 2.5% of the portfolio in the Nasdaq 100 Index ETF (QQQ)
  • Buy 2.5% of the portfolio into the S&P 500 Equal Weighted Index ETF (RSP)
  • Add 1% of the portfolio to build a starter position in Devon Energy (DVN)

ETF Model

  • Buy 2.5% of the portfolio in the Nasdaq 100 Index ETF (QQQ)
  • Buy 2.5% of the portfolio into the S&P 500 Equal Weighted Index ETF (RSP)
  • Add 1% of the portfolio to the SPDR Oil & Gas Exploration ETF (XOP)

Viking Analytics: Weekly Gamma Band Update 6/27/2022

We share the Weekly Gamma Bands Update by Viking Analytics. The report uses options gamma to help you better manage risk and your equity allocations.

The S&P 500 (SPX) found a bottom and began to rally once the lower gamma level was breached. The market continues to be in an amplified “buy the rip” and “sell the dip” mode below the gamma flip level near 4,040.  Our gamma band model enters the week with a 30% allocation to the SPX and will move to a full allocation if the market closes above the gamma flip level.

The chart below shows how price (in black) relates to the gamma flip (in blue) and the lower gamma level (in red).  The Indicator below shows the daily positioning allocations.

The Gamma Band model[1] can be viewed as a trend following model that is shows the effectiveness of tracking various levels relating to option gamma. When the daily price closes below Gamma Flip level, the model will reduce exposure to avoid price volatility and sell-off risk. If the market closes below what we call the “lower gamma level,” the model will reduce the SPX allocation to zero.

The main premise of this model is to maintain high allocations to stocks when risk and corresponding volatility are expected to be low.  For investors who have been conditioned to “buy low and sell high,” it is counter-intuitive to increase allocations when the market rises, but this approach has shown to increase risk-adjusted returns in the back-test.  

Risk management tools like this have become more important than ever to manage drawdowns like the one we are currently in. The Gamma Band model is one of several indicators that we publish daily in our SPX Report (click here for a sample report).  Please visit our website to learn more about our trading and investing tools.

The Gamma Flip – Background

Many market analysts have noted that daily volatility in the S&P 500 will change when the value of the SPX moves from one gamma regime to another.   Some analysts call this level the “gamma flip.”  The scatterplot below shows how price volatility (on the y-axis) is increasingly lower as the value of SPX rises higher above the Gamma Neutral level (on the right side of the chart).  When the value of the S&P closes lower than Gamma Neutral (to the left of the chart), volatility increases. 

Gamma Band Model – Background

The purpose of the Gamma Band model is to show how tail risk can be reduced by following a few simple rules.  The daily Gamma Band model has improved risk-adjusted returns by over 60% since 2007.  The graph below demonstrates how this approach can limit drawdowns while maintaining good returns.  A quick video introduction of the Gamma Band model can be seen by following this link

Disclaimer

This is for informational purposes only and is not trading advice.  The information contained in this article is subject to our full disclaimer on our website.

[1] The Gamma Band model in our SPX Market Report adjusts position size DAILY based upon the daily closing levels of SPX value and calculated Gamma Neutral.  The Weekly Gamma Band model is shown for illustrative purposes only.

Authors

Erik Lytikainen, the founder of Viking Analytics, has over twenty-five years of experience as a financial analyst, entrepreneur, business developer, and commodity trader. Erik holds an MBA from the University of Maryland and a BS in Mechanical Engineering from Virginia Tech.

Rob McBride has 15+ years of experience in the systematic investment space and is a former Managing Director at a multi-billion dollar hedge fund. Rob has deep experience with market data, software and model building in financial markets.  Rob has a M.S. in Computer Science from the South Dakota School of Mines and Technology.


Rate Increase Expectations Are Starting To Fall

Rate increase expectations for the Fed are starting to fall rapidly as recent evidence suggests inflationary pressures are starting to wane. On Friday, stocks jumped more than 2% during the day after the University of Michigan’s gauge of longer-term consumer inflation expectations settled back from an initially reported 14-year high. That drop in inflation expectations potentially reduces the urgency for faster rate increases. St. Louis Fed President Bullard, who is considered the biggest hawk among Fed officials, said worries over a US recession are overblown. 

Traders are starting to price out any Fed action on rate increases beyond the December meeting. The scaling back of the additional rate increases was supportive but it was the expectation of rate cuts by February 2023 that sent stocks rallying. Of course, there is still a lot of work for stocks in the intermediate term, particularly around what happens if an economic downturn takes hold. 

Fed rate expectations

What To Watch Today

Economy

  • 8:30 a.m. ET: Durable Goods Orders, May preliminary (0.2% expected, 0.5% prior)
  • 8:30 a.m. ET: Durables Excluding Transportation, May preliminary (0.3% expected, 0.4% prior)
  • 8:30 a.m. ET: Non-defense Capital Goods Orders Excluding Aircraft, May preliminary (0.1% expected, 0.4% prior)
  • 8:30 a.m. ET: Non-defense Capital Goods Shipments Excluding Aircraft, May preliminary (0.2% expected, 0.8% prior)
  • 10:00 a.m. ET: Pending Home Sales, month-over-month, May (-3.9% expected, -3.9% prior)
  • 10:00 a.m. ET: Pending Home Sales NSA, year-over-year, April (-11.5% prior)
  • 10:00 a.m. ET: Dallas Fed Manufacturing Activity, June (-6.5 expected, -7.3 prior)

Earnings

‌Pre-market

  • No notable companies are set to report.

‌Post-market

  • Nike (NKE) to report adjusted earnings of $0.83 on revenue of $12.14 billion
  • Jefferies Financial (JEF) to report adjusted earnings of $0.51 on revenue of $1.26 billion

Market Trading Update – Stocks Rock

On Friday, stocks surged after the latest UofM Sentiment Survey saw a drop in inflation expectations. Such suggests the Fed will have to be less aggressive on rate increases which stoked the bulls. As noted on Friday, the rally cleared the first resistance level and began to approach the second. Those “gaps” during the waterfall selloff previously are going to provide resistance to the rally. However, we are very close to triggering a MACD buy signal which could provide the support needed for a retracement to the top of the downtrend channel. Our current target for the rally is 4000 where we can rebalance exposures and add back our short S&P 500 index position if needed.

No One Smokes Anymore, But It’s Still Big Business

“After 40+ years of declining cigarette sales and graphic public health warnings about the damage that smoking causes, it might be easy to think of big tobacco as a frail industry on its deathbed — it’s anything but. In fact, even in the wake of falling sales, Altria has eked out record earnings over the last decade. The $12-13bn that it has presumably lost on the Juul deal is an enormous sum… but it’s one that Altria can — quite easily — afford. It’s racked up operating income of more than $10bn for the last 3 years in a row. Big tobacco is still just that… big.” – Chartr

Smoking is still big business

The Philly Fed Survey Suggests An Earnings Recession Is Coming

Between Fed rate increases, rising inflation, and the reversal of liquidity, it is not surprising to see economic indicators coming in weaker than many economists expected. We have written previously about what would happen when the “Sugar Rush” subsided.

That outcome has arrived and was recently noted by the collapse in the Philadelphia Federal Reserve survey. Importantly, earnings expectations remain elevated and have yet to get reduced to compensate for much slower economic growth and a potential recession. Those downgrades are coming which will require further adjustments to stock prices to fully accommodate.

Philly Fed Survey vs Earnings.

The Week Ahead

This week kicks off this morning with durable goods orders, pending home sales, and The Dallas Fed Manufacturing index. Expectations are for durable goods orders to decline 0.3% MoM in May. Tomorrow we’ll get the Conference Board’s Consumer Confidence index and some regional Fed data. Wednesday morning we’ll hear from Chair Powell again before getting a look at May’s PCE data on Thursday. Expectations are for the core PCE price index to increase 4.7% YoY and 0.4% MoM in May. We’ll cap off the week Friday morning with the ISM manufacturing index for June. The consensus is for a slight decrease to 55, down from 56.1 in May.

Energy Prices Could Stay Elevated Longer Than You Think

Underinvestment has plagued the oil & gas industry since the 2015 price downturn and subsequent rise in green agendas. Now Russian sanctions and low inventories are exacerbating the situation but things aren’t showing signs of improvement. Per Bloomberg:

“Investment is set to be below the $441 billion spent in 2019 for a third straight year, endangering future energy security, according to the IEF. The consultant said in a December report with IHS Markit, a research unit of S&P Global Platts, that spending needs to be sustained at about $525 billion a year through 2030 to meet global demand for crude and products.”

A recession would likely soften demand enough to cause a temporary pullback in prices. However, industry underinvestment raises the likelihood that demand quickly overwhelms supply after global central banks inevitably restart QE. The spending landscape isn’t likely to improve either, since the Biden administration had a clear bias against the industry prior to skyrocketing prices. You’re not fooling anyone, Joe. Underinvestment will likely continue, and we could see elevated energy prices after a slowdown. Even when most other supply chains have recovered.

Spending Stalls
Investment Changes

The Looming Risk: Estimate Revisions

Forward valuations look enticing, but that’s only because analysts haven’t revised their estimates lower despite worsening economic conditions. As shown below, analysts still expect earnings growth to accelerate in the third quarter. Meanwhile, Chris Williamson noted in last Thursday’s Flash PMI report that a contraction could begin as soon as Q3. Investors will be in store for more pain when analysts revise estimates lower, as valuations won’t look so rosy anymore.

Earnings Estimates

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Market Fears Subside On Powell’s Testimony

Market fears subsided a bit over the past couple of days as Powell testified before Congress. While Powell believes a recession is not a major risk, other indicators and even the NY Fed disagree. However, Powell said the central bank is open to raising rates again as it works to slow inflation, but he added that the pace of hikes would depend on how quickly inflation starts to decline, based on “the incoming data and the evolving outlook for the economy.”

In recent months, the Fed has accelerated the pace of its interest rate increases, starting with a quarter-point hike in March and a half-point increase in May. That was followed by last week’s bump of three-quarters of a percentage point—the biggest hike in nearly three decades. Such also sparked market fears that a recession would impact growth.

However, those fears somewhat abated when Powell reassured senators the economy was on strong footing and offered optimism about the future.

We are not so sure that is the case.

What To Watch Today

Economy

  • University of Michigan Sentiment, June final (50.2 expected, 50.2 prior)
  • University of Michigan 1-Year Inflation, June final (5.4% expected, 5.4% prior)
  • University of Michigan 5-10-Year Inflation, June final (3.3% expected, 3.3% prior)
  • New Home Sales, May (590,000 expected, 591,000 prior)
  • New Home Sales, month-over-month, May (-0.2% expected, -16.6% prior)

Earnings

‌Pre-market

CarMax (KMX) to report adjusted earnings of $1.53 on revenue of $9.05 billion

Market Trading Update – Rally On Garth

While market action has been very sloppy as of late, it is rallying off of the recent lows from last week.

That’s the good news.

The not-so-good news is that there are several levels of heavy resistance just ahead with the first level getting tested tomorrow. That level is the top where stock prices opened after they gapped down following the Fed rate hike. The second and third levels are the bottoms of each of the waterfall declines that intersect with the tops and bottoms of the previous minor consolidation.

These levels should be used to raise cash and rebalance risk accordingly for now. If we begin to see stronger action in the market that suggests a bottom is forming, we will start an accumulation strategy. However, that is not now.

US Flash PMI Sends Warning Signal

The S&P Global Flash US Composite PMI sank to a level of 51.2 in June from 53.6 in May. The preliminary estimate was the weakest in five months and signals a significant slowdown in the expansion rate of US business activity. The Flash Services PMI fell to 51.6 in June from 53.4 in May (5-month low), and the Flash Manufacturing PMI fell to 52.4 in June from 57.0 in May (23-month low). While services output continued growing, both new orders and manufacturing output decreased for the first time in two years.

Chris Williamson, Chief Business Economist at S&P Global Market Intelligence commented:

“The pace of US economic growth has slowed sharply in June, with deteriorating forward-looking indicators setting the scene for an economic contraction in the third quarter. The survey data are consistent with the economy expanding at an annualized rate of less than 1% in June, with the goods-producing sector already in decline and the vast service sector slowing sharply.”

The report stoked growth fears in the bond market, causing yields to fall for the second straight trading session. Equity markets stumbled but ultimately finished higher.

Flash PMI Composite

Jobless Claims Remain Subdued

Jobless claims for the week ended June 18th were 229k versus a consensus of 227k and a prior reading of 231k. Results were essentially in line with expectations, and although hovering at a five-month high, initial claims remain at unalarming levels. Tightness in the labor market persists despite increasing chatter about layoff plans.

Jobless Claims

Energy Stocks are Correcting Hard and Fast

Energy stocks are taking a break from their insane rally this year as the price of crude oil pulls back. The charts below from Bespoke help put the gravity of the correction into perspective. This is the third worst two-week change for the S&P 500 energy sector in the last 40+ years. Even after the correction, the price of XLE is still up 30% YTD.

Energy 10 day performance
Energy 200dma Spread

China to US Shipping Rates Find Some Relief

Stockpiles of excess inventory at US retailers such as Target (TGT) have led to order cuts in recent months. The cooling of demand is now flowing through to shipping rates, which should offer marginal relief to US wholesalers and retailers. Freight rates from China to the US are down 34% YTD and 50% YoY according to Freightos Baltic Index.

Shipping rates

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Five for Friday- Another Look at Value and Growth

If one can find a bright spot in the market action this year, it’s that value opportunities are growing more plentiful with each leg lower. This week’s screen seeks value stocks with a track record of solid growth and expectations for it to continue. We start with the typical criteria used to find value and refine our results with the PEG ratio and growth criteria. The PEG ratio (P/E divided by expected growth) helps compare valuations of companies that may not be similar.

Screen Criteria

  • Market Capitalization >$10B
  • Price to Earnings <15
  • Forward Price to Earnings <10
  • PEG Ratio <1
  • EPS growth next year >10%
  • EPS growth next 5 years >15%
  • EPS growth past 5 years >15%
  • Sales growth past 5 years >5%

Scan Results

All five stocks are priced attractively given analyst growth estimates as shown below. The group is relatively small; all are mid-cap stocks except for MU (large cap). Two companies operate in the technology sector, and one in each of industrials, discretionary, and energy.

All five stocks look incredibly cheap on a forward P/E basis, but exercise caution. In many cases, analysts still have not revised down their earnings estimates despite a deterioration in the economic outlook getting priced into stocks. This could be a factor at play in some of the stocks featured below.

Scan results

Company Summaries (Corporate Summaries Courtesy of Zacks)

Micron Technology (MU)

Through global brands, namely Micron, Crucial and Ballistix, Micron manufactures and markets high-performance memory and storage technologies including Dynamic Random Access Memory, NAND flash memory, NOR Flash, 3D XPoint memory and other technologies. Its solutions are used in leading-edge computing, consumer, networking and mobile products.

Micron

Ovintiv (OVV)

Ovintiv Inc. is an independent energy producer, which explores and churns out oil and natural gas from diverse assets located in the U.S. and Canada. They acquired Newfield Exploration. A significant portion of the company’s output comes from 3 core unconventional positions in N. America, Montney in British Columbia and Alberta, Anadarko Basin in Oklahoma and the Permian Basin in New Mexico. Its multi-basin premium portfolio also include acreage in N. Dakota s Bakken Shale and the Eagle Ford in Texas. It focuses on growth through a combination of acquisitions and active drilling. The company has consistently posted some of the strongest operational and financial results among the independent oil and gas producers.

Ovintiv

United Rentals (URI)

United Rentals, Inc. is the largest equipment rental company in the world, with an integrated network of rental locations in United States, Canada and Europe. The company’s customer base includes construction and industrial companies, utilities, municipalities, government agencies, independent contractors and homeowners and other individuals that use equipment for projects that range from simple repairs to major renovations. The company s principal products and services are equipment rental, sale of rental equipment, new equipment, contractor supplies, services and other. United Rentals serves customers as a single-source solution, provided through two business segments: General Rentals and Specialty or Trench, Power and Fluid Solutions.

United Rentals

Western Digital (WDC)

Western Digital Corporation is one of the largest hard disk drive producers in the U.S. The company designs, develops, manufactures and markets a broad range of HDDs used in desktop PCs, servers, network-attached storage devices, video game consoles, digital video recorders and a host of other consumer electronic devices. The acquisition of SanDisk enabled the company to venture into the flash drive storage technology space. Western Digital sells hard drives of 3.5-inch and 2.5-inch form factors with storage capacities ranging from 30 gigabytes (GB) to 6 terabytes (TB). The company’s solid-state drives (SSDs) include 2.5-inch, mSATA, MO-297 and CompactFlash form factors, with storage capacities ranging from 128 megabytes (MB) to 400 GB. The company provides WD software applications, such as WD Photos and WD 2GO to the mobile computing market. The company’s solutions are compatible with Apple’s iOS, Google’s Android and Microsoft’s Windows Platforms.

Western Digital

WestRock (WRK)

WestRock is a multinational provider of paper and packaging solutions for consumer and corrugated packaging markets. The company is one of the largest integrated producers of containerboard by tons produced, and one of the largest producers of high-graphics preprinted linerboard on the basis of net sales in North America. It is also one of the largest paper recyclers in North America. The company’s operations outside the United States are conducted through subsidiaries located in Canada, Mexico, South America, Europe, Asia and Australia.

WestRock

Disclosure

This report is not a recommendation to buy or sell the named securities. We intend to elicit ideas about stocks meeting specific criteria and investment themes. Please read our disclosures carefully and do your own research before investing.

“HODL” Finds Its Inevitable Flaw

“HODL,” an original misspelling taken on as a badge of courage by cryptocurrency investors, spread to “Meme stocks” during the runup in 2020 and 2021.

The term “HODL” originated from user GameKyubbi, who posted a drunk, semi-coherent, typo-laden rant about his poor trading skills.

“‘I AM HODLING.’ I type d that tyitle twice because I knew it was wrong the first time. Still wrong. WHY AM I HOLDING? I’LL TELL YOU WHY. It’s because I’m a bad trader and I KNOW I’M A BAD TRADER. Yeah, you good traders can spot the highs and the lows pit pat piffy wing wong wang just like that and make a millino bucks sure no problem bro.

You only sell in a bear market if you are a good day trader or an illusioned noob. The people inbetween hold. In a zero-sum game such as this, traders can only take your money if you sell.” – BitcoinTalk fourm

Within an hour of that post, “HODL” had become a meme. Initially, the memes referenced the movies “300″ and “Braveheart,” but there are now countless HODL memes floating around the internet. 

HODL

Of course, there seemed to be no risk to a “HODL” strategy at the time, as the Federal Reserve and Government pushed trillions of dollars in liquidity into the financial markets and economy. With the economy shut down due to the pandemic, sports gamblers turned their attention to the stock market to get their “fix.” As asset prices surged and with the assistance of the Robinhood app, investing became so easy you could draw letters out of a Scrabble bag.

Unfortunately, when it comes to buying and “HODLing,” the outcome from periods of excess speculation is always the same.

The “HODL” Fallacy

I recently wrote about the problems with “armchair” investment strategies. To wit:

“As shown in the chart below, the advice given is not entirely wrong. Since 1900, the markets have averaged roughly 10% annually (including dividends). However, that figure falls to 8.08% when adjusting for inflation.

By looking at the chart, it’s pretty evident that you should invest heavily in the market and “fughetta’ bout’ it.”

If it was only that simple.”

Real vs Nominal returns for S&P 500

While the average rate of return may have been 10% over the long term, the markets do not deliver 10% yearly. Let’s assume an investor wants to compound their returns by 10% a year over five years. We can do some basic math.

10% annual compounding example.

After three years of 10% returns, a drawdown of just 10% cuts the average annual compound growth rate by 50%. Furthermore, it then requires a 30% return to regain the average rate of return required. 

While an investor can “HODL” for the long term, there is a significant difference between the AVERAGE and  ACTUAL returns received. As I showed previously, the impact of losses destroys the annualized “compounding” effect of money. (The purple shaded area shows the “average” return of 7% annually. However, the differential between the promised and “actual return” is the return gap.)

Promised vs actual returns

The differential between what investors were promised and actual returns is substantial over the long term. Furthermore, you DIED long before realizing the long-term average return rate.

Amid a “bull market,” the impact of losses during the second half of the market cycle becomes obscured. The stronger the bull market advance, the more mistakes investors make by assuming the current cycle will not end as they take on more speculative risk.

Unfortunately, all cycles end.

HODL – Another Word For Speculation

One of the more disappointing developments in the financial markets over the last 12 years has been the rise of “performance chasing” by investors. But such is not surprising given the repeated interventions by the Federal Reserve. As Larry McDonald of the Bear Traps Report noted:

“Inflation is forcing central bankers to allow price discovery. There was always price discovery before Lehman, but for much of the last 12 years markets have been in a Fed zombie trance.

Fed balance sheet vs SP500

Such isn’t “investing,” it’s “speculation.” But who could blame young, inexperienced individuals with a “stimmy” check and promises of quick riches in Bitcoin as it surged daily?

1000 invested in Bitcoin

But it wasn’t just cryptocurrencies. Wall Street supplied traders with SPACs like Lucid Motors when IPOs could not get pushed out fast enough.

1000 invested in LCID

And “Meme” stocks like AMC Movie Theatres got touted on websites like WallStreetBets.

1000 invested in AMC

Of course, the “MoMo” craze got represented best by Cathie Wood and the Arkk ETFs.

1000 invested in ARKK

While “HODLing” worked during the rising bull market, individuals have now discovered holding during a “bear market” can be devastating.

Ultimately, investing is about managing the risks that will substantially reduce your ability to “stay in the game long enough” to “win.”

“The distinction between investment and speculation is a useful one and its disappearance is a cause for concern. We’ve often said Wall Street should reinstate this distinction and emphasize it in its dealings with the public. Otherwise, stock exchanges may some day be blamed for heavy speculative losses which those who suffered them had not been properly warned against.”Benjamin Graham – The Intelligent Investor:

The current bear market is no exception and is the logical outcome of what follows the last advance.

Time To Let Go Of “HODL”

There is a huge market for “get rich quick” investment schemes and programs as individuals keep hoping to find the secret trick to amassing riches from the market. There isn’t one. 

In the 1990s, investors plowed money into speculative investments. Ultimately, they lost most of it at the turn of the century. Then, they turned their focus to real estate, only to get wiped out in 2008. The runup and crash in the cryptocurrencies, disrupter technologies, SPACs, and “Meme” stocks have all met a similar end.

Many believe that investing in the financial markets is their only option for retiring. Unfortunately, they fell into the same trap as most pension funds hoping market performance will make up for a “savings” shortfall. The chart below shows a 6% annual “average” return rate and what stocks historically should return. Starting when returns are high has invariably poor outcomes.

The problem with projections

The damage market declines inflict on investors hoping to garner annualized 8% returns to make up for the lack of savings is all too real and virtually impossible to recover from. When investors lose money in the market it is possible to regain the lost principal given enough time, however, what can never be recovered is the lost “time” between today and retirement. “Time” is finite and the most precious commodity that investors have.

Navigating The Next Cycle

We have previously detailed the basic guidelines for navigating market cycles.

  • Investing is not a competition.
  • Emotions have no place in investing.
  • The ONLY investments you can “buy and hold” are those providing an income stream and return of principal.
  • Market valuations are very poor market timing devices.
  • Fundamentals and Economics drive long-term investment decisions – “Greed and Fear” drive short-term trading.
  • “Market timing” is impossible– managing exposure to risk is both logical and possible.
  • Investment is about discipline and patience. 
  • There is no value in daily media commentary– turn off the television and save yourself the mental capital.
  • Investing is no different than gambling– both are “guesses” about future outcomes based on probabilities.
  • No investment strategy works all the time. 

Before sticking your head in the sand and ignoring market risk based on an article touting “long-term investing always wins, just ‘HODL'” ask yourself who benefits?

Emotions and investment decisions are very poor bedfellows. Unfortunately, most investors make emotional decisions because FEW follow a well-thought-out investment plan. Retail investors generally buy an off-the-shelf portfolio allocation model heavily weighted in equities. The illusion is that stocks will somehow make money over a long enough period. 

Unfortunately, history has been a brutal teacher about the value of risk management. 

Powell Admits Possibility of Recession; Dudley Claims It’s Inevitable

Powell testified before the Senate Banking Committee Wednesday morning. He reaffirmed the Fed’s commitment to lowering inflation but admits that achieving a soft landing will be “very challenging”.

Powell also uttered the “R” word as he acknowledged the possibility that rate hikes could trigger a recession. Powell’s comments sent bond yields lower across the curve and put a halt to stocks’ advance on the day. In contrast to the light-footed messaging by Powell, Bill Dudley authored an opinion piece declaring that a recession is inevitable within the next 12 to 18 months.

What To Watch Today

Economy

  • 8:30 a.m. ET: Current Account Balance, Q1 (-$275.0 billion expected, -$217.9 billion prior)
  • 8:30 a.m. ET: Initial Jobless Claims, week ended June 18 (226,000 expected, 229,000 prior)
  • 8:30 a.m. ET: Continuing Claims, week ended June 11 (1.320 million expected, 1.312 million prior)
  • 9:45 a.m. ET: S&P Global U.S. Manufacturing PMI, June preliminary (56.3 expected, 57 prior)
  • 9:45 a.m. ET: ET: S&P Global U.S. Services PMI, June preliminary (53.5 expected, 53.4 prior)
  • 9:45 a.m. ET: ET: S&P Global U.S. Composite PMI, June preliminary (53.6 prior)
  • 11:00 a.m. ET: Kansas City Fed Manufacturing Activity, June (23 prior)

Earnings

Pre-market

  • FactSet Research (FDS) to report adjusted earnings of $3.21 on revenue of $476 million
  • Rite Aid (RAD) to report an adjusted loss of 66 cents on revenue of $5.7 billion
  • Apogee Enterprises (APOG) to report adj earnings of 55 cents on revenue of $326.22 million

‌Post-market

  • FedEx (FDX) to report adjusted earnings of $6.86 on revenue of $24.57 billion
  • BlackBerry (BB) to report an adjusted loss of 5 cents on revenue of $163.5 billion

Market Trading Update – Stocks Recover Early Losses

After yesterday’s strong rally, stocks opened lower ahead of Jerome Powell’s testimony before the Senate. Shortly after the open stocks staged a strong rally back into positive territory and remained above breakeven the rest of the day. The good news is that action confirms we are likely to see some more buying over the next few days. The bad news is that volume and conviction remain very weak and whatever rally we currently get to end just as quickly as it began.

Use the price advance over the last couple of days to start taking profits and raising cash. If we get some more follow-through we will look to add our short S&P index position back into portfolios.

Bond Yields Are About To Catch Down

My colleague Albert Edwards from Societe Generale had a great note out yesterday showing that bond yields have yet to “catch down” to economic growth. (Such is why we remain long bonds as a hedge.)

“Perhaps the more interesting question is not how deep the recession will be, but how large the fall in yields will be? The recent inflation surge broke the close link between the real economy data and bond yields (see chart below). Will a recession dispel inflation fears (temporarily) and drive bond yields substantially lower?

The outlook for commodities is key, especially with the backdrop of the war in Ukraine. But I still see commodity prices plunging just like in Q4 2008, back then taking headline CPI inflation from +5% to -2% in just 12 months. Could we see sub-1% 10y yields once again? Now that would be one heck of a surprise.”Albert Edwards

US Bond Yields vs Economic Data GDP

The Tale Of A Zombie Company

Revlon, the beauty and cosmetics company first founded in 1932, has filed for bankruptcy. For years Revlon, which owns Elizabeth Arden and a number of fragrance lines (including Britney Spears and Christina Aguilera’s brands), has struggled with a growing debt pile. From 2009-2015, Revlon mostly had that debt under control, eking out enough of a margin to cover the annual interest expense every year.

That last sentence is THE definition of a “zombie company.” Now back to the rest of the story.

“But then Revlon acquired Elizabeth Arden in a bid to buy its way to growth. That meant taking on more debt, at a time when competition in the beauty space was intensifying. Revlon started to struggle. Having been reliant on physical distribution in malls and shops for years, Revlon suddenly had to compete with upstart brands such as Fenty Beauty (by Rihanna) or Kylie Cosmetics (by Kylie Jenner).

These were digitally-native brands with huge followings that shipped straight to consumers, meaning cheaper marketing and distribution. Fenty Beauty has 12.9m followers across social media platforms Instagram and TikTok, Kylie Cosmetics has 28.9m.

Revlon has 3m.

As debt piled up Revlon shifted some assets into a new holding company, in an attempt to attract new lenders. That was fine except it wasn’t — Revlon’s long-time lenders sued, alleging that the company had breached their loan agreements. That’s complicated enough but it became comically complicated when Citibank — which was acting as a loan agent — accidentally paid off $900m of Revlon loans with its own money. Citi said, “oops sorry can we have that back”. Some of the counterparties said yes, but others weren’t so keen to forgive and forget, leaving Citi out of pocket for Revlon’s loans… and now Revlon is going bankrupt.” – Chartr

Revlon operating profit and interest expense.

Equity Risk Premium Is Too Low To Suggest Recession Risks Are Over

“With Michael Wilson’s view for lower multiples and earnings now more consensus, the markets are more fairly priced. However, it does not price the risk of a recession, in his view, which is 15-20% lower, or roughly 3000. The Bear market will not be over until the recession arrives or the risk of one is extinguished. What do forward EPS contractions look like in the absence of a recession and during a recession?

Forward EPS contractions over 2% are fairly rare. During non-recessionary times, the median EPS contraction is about 5%. During recessions, EPS contractions ramp up to 14%. Such a decline would take the consensus of $239 today down to $206; putting a 14/15x trough multiple on this implies a price range of 2,900 to 3,100.” – The Market Ear

Equity Risk Premium

Powell’s Testimony

Here are some headlines from Powell’s testimony yesterday:

  • “Powell: Fed Rate Hikes Won’t Bring Down Gas or Food Prices”
  • “Powell Says US Economy Very Strong, Can Handle Tighter Policy”
  • “POWELL: ONGOING HIKES APPROPRIATE, DECISIONS MEETING BY MEETING”
  • “Powell Says Fed Strongly Committed To Returning Inflation To 2%”
  • “Powell: Rate Rises Should Impact House Prices Fairly Quickly”
  • “Powell: We Are Seeing a Slowing in Housing”
  • “POWELL: OUR GOAL IS FOR A SOFT LANDING, GOING TO BE VERY CHALLENGING
  • POWELL: CERTAINLY A POSSIBILITY OF RECESSION, NOT OUR INTENTION
  • “Fed’s Powell When Asked About A Rate Hike Of 100 Basis Points: I Will Never Take Anything Off The Table.”

Dudley Signals Doom

Bill Dudley, Former President of the New York Fed, said a recession is inevitable within the next 12-18 months in an opinion piece published yesterday. We summarize his thinking as follows: Price increases have clearly forced the Fed to shift focus to price stability, with employment taking a back seat for now. The last thing the Fed wants is to fail at controlling inflation. If inflation expectations become unanchored, the situation becomes a lot harder to fix.

He then contends that it will take time and considerable tightening for significant demand reduction and supply adjustment. When that time comes, the economy will downshift abruptly due to tight conditions, a damaged consumer, and fading tailwinds. Finally, Dudley refers to history. He claims the Fed has never tightened enough to push unemployment up by 0.5% or more without triggering a recession. However, this is exactly what the FOMC members forecast at their last meeting. Although, the Fed rhetoric is quickly morphing as Powell now admits that recession is a possibility. Dudley’s conclusion is clear:

“Much like Wile E. Coyote heading off a cliff, the US economy has plenty of momentum but rapidly disappearing support. Falling back to earth will not be a pleasant experience.”

US Refining Capacity Dips Further

According to the federal government’s annual refinery capacity report, US capacity fell to the lowest level since 2014 at the beginning of this year.

“The dip comes amid refinery closures in recent years and the recent surge in oil prices as retail gasoline and diesel costs hit record highs earlier this year. The new pricing records are coming from a combination of factors, including demand recovery from the pandemic and the ongoing war in Ukraine.”

Refining Capacity

The crimped refining capacity and demand recovery have led to record crack spreads for refiners as shown below. The 2nd chart below illustrates that refiners have been increasing capacity utilization this year, and it’s approaching levels seen pre-pandemic.  

Crack Spread
Capacity Utilization

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When Will “The Bottom” Be In? History Points to the Fed

The trillion-dollar question on nearly every investor’s mind lately is “When will the market bottom be in, and how will I know?” Unfortunately, we can’t tell you where the market bottom is. No one can. Fortunately, history points to Fed policy as a place to look more often than not. The Wall Street Journal notes,

“Going back to 1950, the S&P 500 has sold off at least 15% on 17 occasions, according to research from Vickie Chang, a global markets strategist at Goldman Sachs Group Inc. On 11 of those 17 occasions, the stock market managed to bottom out only around the time the Fed shifted toward loosening monetary policy again.”

It’s unlikely that the trend breaks in this situation. Although, markets may begin sniffing out a policy pivot well before it goes on the record.

What To Watch Today

Economy

  • 7:00 a.m. ET: MBA Mortgage Applications, the week ended June 17 (-6.6% prior)

Earnings

Pre-market

  • Korn Ferry (KFY) to report adjusted earnings of $1.56 on revenue of $682 million
  • Winnebago (WGO) to report adjusted earnings of $2.96 on revenue of $1.22 billion

Post-market

  • KB Home (KBH) to report adjusted earnings of $2.01 on revenue of $1.65 billion

Market Rallies. Is The Bottom In?

As discussed in this past weekend’s newsletter, the market did bounce yesterday after the melt-down last week. However, while the rally was a welcome relief, it is likely to be short-lived as a rising number of “trapped longs” continue to look for an exit.

With the market oversold on multiple levels, a short-term bottom and a reflexive rally are likely. Such could be quite strong with the market retracing to the top of the downtrend channel which has been its “M.O.” this year. That retracement would take the market back to roughly 3900-4000 on the index. Such would be a good target to reduce equity exposure, raise some cash, and hedge.

If the market breaks above that downtrend and triggers a MACD buy signal we will need to re-evaluate current positioning and risks accordingly. However, I suspect the downtrend remains intact for now until the Fed starts to “pivot” in their more aggressive monetary policy.

Daily trading chart market commentary

FOMC Likely To “Pivot” Sooner Than Expected

While the Fed is talking a tough game about combatting inflation, the reality is that they are much more worried, and beholden to, financial instability. As noted yesterday on Twitter:

Notably, the market agrees with my comments and is now pricing in Fed rate cuts in the first half of 2023. That date will get moved up as a recession becomes more evident.

Fed funds futures pointing to Fed pivot

Equity Returns Following Inflation Peaks

“A wide distribution of outcomes for equities past the inflation peak, with growth the key determinant for the trajectory. But any way you look at it, equities are up 12 months post inflation peak. Chart shows S&P00 total return. Data since 1955” – @themarketear

Equity returns following inflation peaks and market bottoms.

Existing Home Sales Fall Again

Existing Home Sales data for May were in-line with expectations (5.41M vs 5.4M consensus). However, May was the fourth straight monthly decline in sales volume as higher mortgage rates begin catching up with the housing market. The figure (-3.4% MoM) is 8.6% lower than a year ago, and it represents the weakest annualized rate of existing home sales since June 2020.

Despite the slowdown in sales volumes, higher mortgage rates are not yet fully reflected in the data. The Wall Street Journal notes,

“While demand is slowing, price growth remains rapid. The May figures largely reflect purchase decisions made in April or March. Nearly 60% of homes sold in May were sold above their list price, according to real-estate brokerage Redfin Corp.”

It may still be a few months until mortgage rates begin really showing up in data, as we noted in Friday’s daily update.

Existing Home Sales

NY Fed Model at Odds with FOMC Projections

The latest forecast from the New York Fed’s DSGE macro model is quite pessimistic compared to the views of FOMC members. As shown in the first figure below, the NY Fed model forecasts economic contractions in both 2022 and 2023. Meanwhile the model forecasts Core PCE inflation to be 3.8% and 2.5%, respectively.

The second figure below highlights the median forecast by FOMC members for the same metrics. The median forecast has GDP growth near the longer-run rate in 2022 and 2023 with core PCE inflation hotter than the NY Fed model. Only time will tell which forecast ends up more accurate. History points to both being of little use, but they are certainly at odds with one another. So if anything, this should serve to contrast the Fed’s fixation on a soft landing with other distinct possibilities.

NY Fed Model Forecasts
FOMC Projections

Kellogg Spinoff into Three Businesses

Kellogg (K) announced Tuesday morning that it will split into three separate businesses in a bid to enhance performance. The three businesses will consist of its global snack brands, its legacy cereal business, and its newer plant-based foods operation. It plans to name the businesses Global Snacking Co., North America Cereal Co., and Plant Co., respectively.

Splitting into three firms increases competitiveness in each business line- driving growth opportunities that may otherwise be difficult to exploit. Management expects its Global Snacking Co. to grow at a faster pace than Kellogg by leveraging scale in emerging markets. Meanwhile, the now pure-play plant-based food business will gain focus and flexibility, leading to greater competitiveness with incumbents like Beyond Meat (BYND). The that end the CEO Steve Cahillane noted,

“These businesses all have significant standalone potential, and an enhanced focus will enable them to better direct their resources toward their distinct strategic priorities.”

History points to positive results for this transaction. Kraft Foods executed a similar move in 2012 to create Mondelez International (MDLZ). MDLZ has since more than doubled in value.


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The Real Reasons for Inflation

The Real Reasons for Inflation

Let’s discuss the most discussed topic in the economy and the markets – INFLATION. Inflation, which is the increase in prices, not the absolute level of prices, has reached a 40-year high (CPI) of 8.5%. In this report, we will discuss the most likely reasons that inflation has chosen this moment to rear its ugly head. Why did it happen and who’s at fault for letting the monster in the door. These are reasonable questions since we have enjoyed very low inflation of less than 3% for so many years.

There are many possible culprits for today’s rapidly rising prices, such as Russia’s invasion of Ukraine, Covid stimulus programs, Supply disruptions, lack of housing, and corporate greed. TPA has examined and will present the evidence to show that the most likely reason for today’s rapidly rising prices is a combination of a necessary package of stimulus, lingering supply-chain issues, pent-up demand, and a public that is enjoying true freedom to spend for the first time in over 2 years. TPA will point, in particular, to the last factor as presenting the best timing for the recent high inflation.

TPA’s four conclusions:

  • GOVERNMENT AND FED DID THE LOGICAL THING.

Given the scenario present 2 years ago, the choices were to (1) do little or nothing in face of massive job shutdowns, unemployment, supply disruptions, and business disruption, risking a major recession or worse or (2) enact a stimulus package, moratoriums on evictions and bankruptcies, and school loan deferments; all of which risked creating inflation. The government and the FED chose the most logical actions given the emergency they faced. Logic demanded choosing (2).

  • UKRAINE IS NOT THE MAIN ISSUE.

Inflation began well before Russia invaded Ukraine. The conflict may have exacerbated the problem, but it is not the main cause. Russia did not invade Ukraine until 2/24/22. At that point, inflation was already rampant:

  • CPI YOY                                    +7.87%
  • CPI Food YOY                          +7.90%
  • CPI Energy YOY                      +25.55%
  • FED Balance Sheet                 $8.9 trillion
  • Average Home Price YOY      +21.31%

Stimulus actions in the U.S. are not the main cause of inflation. Evidence of this is that inflation is not just a U.S. problem; it is a worldwide problem. Even countries that did not enact massive stimulus are experiencing inflation.

  • TIMING POINTS TO A COMBINATION OF PENT-UP DEMAND & SUPPLY CONSTRAINTS.

The most likely reason for inflation was pent-up demand and supply shortages after 2 years of Covid. The timeline of rising prices coincides more closely with the decline in the Covid mortality rate and the loosening Covid restrictions more than any other factors.

The rise in prices can be seen by tracking the relaxing of mandates and restrictions on the U.S. public. The chart below shows inflation data from 2012 until present, along with Covid milestones. The point at which inflation ramps up correlates more or less with the CDC announcement that people can gather indoors without masks. Specifically, the chart below shows CPI YOY (year over year), CPI Energy YOY, CPI Food YOY, Average Home Prices YOY, and the FED Balance sheet for the past 10 years. TPA has also shown the timing of each of the Covid stimulus programs and the point at which Russia invaded Ukraine. TPA sees 3 things from this chart:

  1. CPI remained in line until the very last Covid program, America Rescue Plan.
  2. CPI only starts to ramp up after the 1st quarter of 2021
  3. CPI was in full swing well before Russia invaded Ukraine

Price table provided at the bottom of this report.

The simplified chart below of just U.S. CPI and the FED Balance sheet shows the same thing as above. Inflation spiked once Covid restrictions were removed.

FED Balance Sheet, U.S. CPI

The chart below shows the CPI of the U.S. EU, Brazil, and India. It is obvious from this chart that the U.S. is not the only country experiencing inflation. In addition, other large countries have experienced much worse inflation. Not all countries enacted giant stimulus programs to counteract the effects of Covid and yet almost the entire world is experiencing a rapid rise in inflation.

The chart below also lists the various stages of the Pandemic and highlights that the moment that inflation took off coincides with the CDC fully relaxing mask mandates. This factor, more than any other, seems to align more closely with the start of the current inflation spike.

The map below shows that there are no longer any statewide mask mandates.

https://www.multistate.us/issues/covid-19-policy-tracker

The chart below shows that, although Covid cases continue, the fatality rate of Covid has plummeted, making travel and normal activity much safer. This allowed the Americans the freedom to travel, go out to eat, and spend.

https://ourworldindata.org/mortality-risk-covid

Sources:

https://www.bls.gov/cpi/

https://fred.stlouisfed.org/series/ASPUS

https://www.pgpf.org/blog/2021/03/what-to-know-about-all-three-rounds-of-coronavirus-stimulus-checks

https://www.sba.gov/funding-programs/loans/covid-19-relief-options/paycheck-protection-program/first-draw-ppp-loan

This Week’s Top 10 and Bottom 10.

 Click the image below for all charts.

Viking Analytics: Weekly Gamma Band Update 6/21/2022

We share the Weekly Gamma Bands Update by Viking Analytics. The report uses options gamma to help you better manage risk and your equity allocations.

The S&P 500 (SPX) fell sharply on Monday and Thursday and consolidated the other trading days of last week. From an options re-hedging and risk standpoint, the market could see additional drawdowns next week as the market digests the rolling and adoption of new hedges. The market continues to be in an amplified “buy the rip” and “sell the dip” mode well below the gamma flip level near 4,055.  Our gamma band model enters the week with a 0% allocation to the SPX and will not enter a partial long position unless the SPX over takes the lower gamma level, currently near 3,720.  

The Gamma Band model[1] can be viewed as a trend following model that is shows the effectiveness of tracking various “gamma” levels. When the daily price closes below Gamma Flip level, the model will reduce exposure to avoid price volatility and sell-off risk. If the market closes below what we call the “lower gamma level,” the model will reduce the SPX allocation to zero.

[1] The Gamma Band model in our SPX Market Report adjusts position size DAILY based upon the daily closing levels of SPX value and calculated Gamma Neutral.  The Weekly Gamma Band model is shown for illustrative purposes only.

The main premise of this model is to maintain high allocations to stocks when risk and corresponding volatility are expected to be low.  For investors who have been conditioned to “buy low and sell high,” it is counter-intuitive to increase allocations when the market rises, but this approach has shown to increase risk-adjusted returns in the back-test.  

Risk management tools like this have become more important than ever to manage the next big drawdown. We incorporate many options-based signals into our daily stock market algorithms. Please visit our website to learn more about our trading and investing tools.

The Gamma Band model is one of several indicators that we publish daily in our SPX Report (click here for a sample report). 

The Gamma Flip – Background

Many market analysts have noted that daily volatility in the S&P 500 will change when the value of the SPX moves from one gamma regime to another.   Some analysts call this level the “gamma flip.”  The scatterplot below shows how price volatility (on the y-axis) is increasingly lower as the value of SPX rises higher above the Gamma Neutral level (on the right side of the chart).  When the value of the S&P closes lower than Gamma Neutral (to the left of the chart), volatility increases. 

Gamma Band Model – Background

The purpose of the Gamma Band model is to show how tail risk can be reduced by following a few simple rules.  The daily Gamma Band model has improved risk-adjusted returns by over 60% since 2007.  The graph below demonstrates how this approach can limit drawdowns while maintaining good returns.  A quick video introduction of the Gamma Band model can be seen by following this link

Disclaimer

This is for informational purposes only and is not trading advice.  The information contained in this article is subject to our full disclaimer on our website.

[1] The Gamma Band model in our SPX Market Report adjusts position size DAILY based upon the daily closing levels of SPX value and calculated Gamma Neutral.  The Weekly Gamma Band model is shown for illustrative purposes only.

Authors

Erik Lytikainen, the founder of Viking Analytics, has over twenty-five years of experience as a financial analyst, entrepreneur, business developer, and commodity trader. Erik holds an MBA from the University of Maryland and a BS in Mechanical Engineering from Virginia Tech.

Rob McBride has 15+ years of experience in the systematic investment space and is a former Managing Director at a multi-billion dollar hedge fund. Rob has deep experience with market data, software and model building in financial markets.  Rob has a M.S. in Computer Science from the South Dakota School of Mines and Technology.


Oil Price Reversions – The Inevitable Outcome Of Recessions

An oil price and energy stock price reversion may be starting. The reason is that oil price reversions are the inevitable outcome of economic recessions. Of course, such is due to the previous price spikes that create demand destruction in the economy.

The chart shows the price of oil since 1946.

Oil prices

Higher oil prices benefit oil companies by making the extraction process more profitable. However, there is also a negative impact on the economy.

“High oil prices add to the costs of doing business which pass, ultimately, on to customers and businesses. Whether it is higher cab fares, more expensive airline tickets, the cost of apples shipped from California, or new furniture shipped from China, high oil prices can result in higher prices for seemingly unrelated products and services.” – Investopedia

Of course, consumers who fill up their gas tanks each week immediately notice high oil prices. While core inflation reports strip out food and energy, those items drive short-term consumption patterns. Given that consumption comprises roughly 70% of the GDP calculation, the impact of higher oil prices is almost immediate.

As shown below, spikes in oil prices have a high correlation with economic recessions, financial events, and oil price reversions.

Oil prices and events

The Link To Oil

Oil prices are crucial to the overall economic equation. As prices increases, it translates into higher inflationary costs to consumers. Unsurprisingly, there is a high correlation between the rise and fall of energy prices and the consumer price index.

Oil prices and inflation

Oil prices impact virtually every aspect of our lives, from our food to the products and services we buy. Therefore, the demand side of the equation is a tell-tale sign of economic strength or weakness. As shown, oil prices track our combined rates, inflation, and GDP index. 

The link to oil and economic composite

Given that the oil industry is very manufacturing and production intensive, rising oil prices increase manufacturing, CapEx, and economic growth. It also works in reverse.

“It should not be surprising that sharp spikes in oil prices have been coincident with downturns in economic activity, a drop in inflation, and a subsequent decline in interest rates.

Energy price surges and recession

The most recent surge in oil prices resulted from the massive flood of fiscal policy and a supply shortage. During the last few years, an aggressive political and Wall Street “green energy” campaign restricted drilling and refinery permitting. Those policies reduced capital formation for drilling projects and removed oil exploration incentives.

While the pandemic-driven shutdown of the economy created a supply shortage, the flood of liquidity inevitably created a demand surge. That “pull-forward” of consumption led to surging inflationary pressures and rising oil prices. We show the high correlation between oil prices and breakeven inflation rates.

Breakeven inflation and oil

The short version is that oil prices reflect supply and demand. With liquidity reversing, economic demand is weakening as the cost of living outpaces real wages. As shown, the correlation between oil spikes and declines in economic growth (3-year average growth rate) should not be surprising.

Oil prices events and GDP

Warning Signs Of The Next Oil Price Reversion

While many analysts are talking about $200/bbl oil, it is just as possible that oil prices could fall to $60. After all, it wasn’t so long ago that oil prices went negative for a short period.

With the U.S. economy on the verge of a recession, the risk of a deflationary backdrop is rising.

Atlanta Fed GDPNow

Furthermore, retail sales are also showing problems with consumption. Retail sales get measured in “dollars” rather than “volume.” So, the most recent decline in retail sales was a drop in volume purchased as prices rose.

Retail sales and oil prices

Naturally, slower economic growth and deflationary pressures will contribute to an oil price reversion as consumers opt to drive less. Lastly, Federal Reserve rate hikes, and balance sheet reductions, extract liquidity from speculative trading. Such is why commodities, particularly oil, tend to crash regularly.

Energy sector vs Fed funds.

While the recent rally in energy stocks has been quite strong, the Fed is about to aggressively tighten monetary policy with the sole goal of combating inflation. In other words, to bring down inflation, they will slow economic growth, which reduces demand for commodity-based products.

Unfortunately, if history repeats, it won’t be just oil prices and energy stocks that get brought down in the process.

Is A Tradable Bottom In Sight?

The stock market is having its worst week since March 2020 when the Pandemic first rocked the economy. This time the aggressive monetary policy is worrying investors. While there are many debates about whether this is a bear market, we must acknowledge it is a bearish trend. As investors, we must then ask if the recent stock washout is creating a tradable bottom, or is there more pain to follow?

A tradable bottom allows investors to partake in some upside and recoup some losses. We suspect a tradable bottom is near. Accordingly, we removed our S&P 500 hedge on Friday. If the tradable bottom shows more promise, it may be wise to add to our stock exposure. The bigger question is whether said bottom is THE bottom of the bearish trend, or is the rally an opportunity to rebalance, take more protective measures, and brace for even lower prices?

Our Daily Commentary and SimpleVisor Buy Sell Reviews allow us to share our thoughts on important questions like those we pose above.

What To Watch Today

Economy

  • Chicago Fed National Activity Index, May (0.47 prior month)
  • Existing Home Sales, May (5.40 million expected, 5.61 prior month)
  • Existing Home Sales, month-over-month, May (-3.7% expected, -2.4% prior month)

Earnings

Pre-market

  • Lennar (LEN)

Post-market

  • La-Z-Boy (LZB)

Is A Tradable Bottom Near

At previous market bottoms, the Fed was cutting rates to zero, introducing QE programs, or providing other measures of monetary liquidity. Today that is not the case, as the Fed is just starting to reduce its balance sheet and hike interest rates aggressively. The reversal of liquidity suggests that any short-term bottom in stocks may be tradable bottoms, but not “the” bottom, particularly as the economy approaches earnings and economic recessions.

Fed Bluffs, Fed Bluffs And Wall Street Calls

With the market completing a “head and shoulders” topping process and violating important support at the 38.2% Fibonacci retracement level, the next logical support is 3500. Such a correction would wipe out all the gains since the 2020 peak. Such would also push the S&P 500 index nearly 4-standard deviations below the 50-day moving average.

If the market fails to find support at 3500, 3196 becomes the next logical level.

However, the market is currently showing several signals aligned with previous market bottoms. Currently, only 2.6% of stocks in the S&P 500 index are trading above their 50-day moving average. Moreover, only 12.4% are above their respective 200-dma. As shown, with the market oversold and so many stocks trading below their respective moving averages, such typically denotes market lows.

Fed Bluffs, Fed Bluffs And Wall Street Calls

Furthermore, the market selling as of late has been brutal. As noted by BofA:

“More than 90% of stocks in the S&P 500 declined today. It’s the 5th time in the past 7 days. Since 1928, there have been exactly 0 precedents. This is the most overwhelming display of selling in history.”

While none of this data “guarantees” a market bottom is near, history suggests the odds of a reflexive rally remain elevated. We also suspect Wall Street will call the “Fed bluff” on aggressive monetary policy sooner than later.

The Week Ahead

On Wednesday and Thursday, Chairman Powell will likely spark investor interest when he testifies on monetary policy, the economy, and inflation to Congress. We suspect he will tote the party line and fully commit to fighting inflation. It will be interesting to see how he handles concerns that fighting inflation entails job losses.

The economic calendar is light. Of note will be existing home sales for May. Houses that were sold in May were likely negotiated for in February or March when mortgage rates were much lower. Accordingly, the data may not represent what is truly going on in the housing sector. Similarly, new home sales, due out on Friday, are fraught with a similar data lag. The Chicago Fed National Activity Index will provide its latest update on the state of the national economy. It is expected to fall but remain in economic expansion territory.

The Building “Bricks” Of A Remarkable Business

“This week iconic toymaker Lego announced its plan to build a new 1.7 million-square-foot factory in Virginia, creating up to 1,800 jobs once complete. The Danish company plans to spend $1bn on the factory, which is an enormous investment for any company, let alone one that produces such a simple product.

But selling a simple product, and doing it really, really well, has been the cornerstone of Lego’s remarkable business model. Sales last year jumped 27%, a number that some cash-burning tech companies would have been happy with. All told Lego sold ~55bn Danish Kroner worth of plastic bricks in 2021, squeezing out a 31% margin on those sales thanks to the company’s iconic brand and build quality, with a reported manufacturing error rate of just 18-in-a-million.

In USD Lego sales work out to around $7.8bn — suggesting that its factory investment, which will presumably be spread over 3 years, will only cost around ~4% of Lego’s sales over that period. Lego is betting big that playing with plastic bricks is here to stay. They’re probably right.” – Chartr

Lego

Energy vs. Tech- A Tale of Two Sectors

The Bloomberg graph below shows the stunning divergence between the tech and energy sectors. Currently, 90% of stocks in the energy sectors are trading above their 200 dmas. At the same time, only 1% of tech stocks exceed their 200 dmas. One only has to look back to 2020 to see a similar divergence. Through most of 2020, it was the energy sector with a small percentage of constituents trading above their 200 dmas. And, most tech stocks were increasingly surpassing their 200 dmas.

Just because the divergence is extreme doesn’t mean it can’t continue for a while. However, in the coming months, it is likely to revert. Will energy stocks finally break and trade below their 200 dma? Such argues for an extended bear market. Or, will tech stocks retake their 200 dma, in what may signal a bullish trend for the markets?

energy vs technology

Central Banks Are All Over the Monetary Map

Last week many of the world’s major central banks held monetary policy meetings and took action. As shown below, the policy prescriptions for weaker economic activity and inflation spanned a vast chasm. The Fed was the most aggressive, with a 75 bps rate hike and a commitment to fight inflation aggressively. On the other side of the spectrum is the Bank of Japan. On Friday, they announced that they would continue to do as much QE as is needed to cap its 10-year yield at 0.25%. They clearly remain willing to prop up their economy and ignore rising inflationary pressures and the weakening yen. The graph below shows how the BOJ’s actions put a kink in its yield curve. The yield should be closer to 0.40% if they leave it alone.

  • Fed: Hikes rates 75bps
  • Switzerland (SNB): Hikes rates by 50bps
  • England (BoE): Hikes by 25bps
  • Europe (ECB): Working on a plan to hike rates this summer and will stop QE
  • Japan (BoJ): Monetary guns blazing. Will defend cap on ten-year yields and “short & long term policy rates to remain at present OR LOWER levels.”
japanese boj central bank

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Portfolio Trade Alert – June 17, 2022

Trade Alert For Equity & ETF Models

With the market back to more extreme oversold levels on a short-term basis, and trading into 3-standard deviations below the 50-dma, we are set up for a decent reflexive rally back to 4000 on the index. While there is downside risk to the markets currently, we are well underweight equities and are holding a large cash position. Therefore, we are going to take the profits in the remaining shares of our Short S&P 500 Index (SH) trade and look to add back that hedge on any rally.

Equity & ETF Models

  • Sell 100% of the S&P 500 Short ETF (SH)

Philadelphia Fed, Like Atlanta Fed, Signals Weakness

On Wednesday, the Atlanta Fed revised its Q2 growth estimate to 0.0%. Yesterday, the Philadelphia Fed Index fell into economic contraction territory. It was the first time since 2020 that the Fed’s survey of Philadelphia area manufacturers contracted. More concerning is the outlook. The six-month Philadelphia Fed outlook, shown below, fell below zero for the first time since 2008. Driving the dour outlook in the Philadelphia Fed survey is new orders which fell sharply to -12.4, and future shipments, which fell 29 points to 3.6. As a result, the future employment index fell from 29.5 to 10.5. While employment is still positive, manufacturers are bracing for a slowdown.

We would like to believe Powell’s sentiment that “there is no sign of a broader slowdown in the economy,” still, the reality is that many real-time measures of economic activity, like the Philadelphia Fed report, signal an abrupt slowdown and possible recession.

philadelphia fed outlook

What To Watch Today

Economy

  • Industrial Production, month-over-month, May (0.4% expected, 1.1% prior)
  • Capacity Utilization, May (79.3% expected, 79.0% prior)
  • Manufacturing (SIC) Production, May (0.2% expected, 0.8% prior)
  • Leading Index, May (-0.4% expected -0.3% prior)

Earnings

Pre-market

  • No notable reports are set for release.

Post-market

  • No notable reports are set for release.

Market Trading Update – Market Calls Fed’s Bluff

While Jerome Powell may see no recession on the horizon, the Philadelphia Fed index, and the market all disagreed. Yesterday, the market sold off sharply across sectors as the risk of a recession is rising sharply as the Fed hikes rates.

As shown, the market is deeply oversold on a short-term basis and is trading at the bottom of the current downtrend range. Following today’s massive options expiry, I would not be surprised to see a bounce. However, while that bounce could be fairly strong, I would expect it to fade at roughly 4000 on the S&P 500 as trapped longs look for their next exit.

The Fed May, Or May Not, Have Your Back

US high yield spreads closed above 500bps for the first time since late 2020 when it was on the way down. The last time it closed above in a broader uptrend was 28 February 2020. Remember that there is a lot of oil in here, so very different macro backdrop vs 2020. – MarketEar

Higher Mortgage Rates Are Beginning to Take a Toll on Housing

The graph below from Redfin shows that home sellers are reducing prices at the fastest pace since 2019. The data below is rolling, which can skew the result. Per Redfin:

The housing market is sending clearer signals that the pandemic-driven housing frenzy is coming to an end. Nearly one in five (19.1%) home sellers dropped their price during the four week period ending May 22—the highest level since October 2019.

redfin house price housing

Housing Starts and Building Permits data released yesterday further confirm Redfin’s views. Housing starts in May fell 14.4% after rising 5.5% in April. Building permits dropped 7% following a 3.2% decline in April. Investors seem to be pricing in a poor outlook for homebuilders. The Home Builder ETF XHB is down 38% this year, about twice as much as the S&P 500.

6.00% mortgages are taking a toll on the robust housing market. While we can see home price reductions and houses sitting on the market today, it will take a few months for this data to feed through to official measures of home sales activity and home prices. Over a third of CPI and about 15% of GDP is based on housing.

xhb homebuilders housing

Optimism from TPA Analytics

Our colleague Jeffery Marcus from TPA Analytics penned the following research. He notes that since 1945, market declines of over 19% are buying opportunities.

To find a roadmap for going forward, TPA looked back over the past 77 years or since World War II to see what happened after previous bear markets. After some initial research, we broadened our scope to include an additional 2 occurrences in 2011 and 2018, in which the declines were a fraction shy of the normally required -20% (2011 -19.39% and 2018 -19.78%). TPA found that, although in some cases it required some grit to see it through, in an overwhelming majority of cases, buying after bear market declines rewarded investors 1 year out.

His table below with the “bear market” instances shows that there have only been two bear markets in which a 19%+ decline was not met with gains over the next year. Those two instances were 2001 and 2007, the last two recessions.

tpa analytics

What Drives Gasoline Prices?

The illustration below from the Visual Capitalist highlights the four main drivers of gasoline prices. As they share, slightly over half of the gas price is a function of the price of crude oil. The remaining influences are divided equally between taxes, distribution & marketing, and refining costs. Taxing oil producers or asking refiners to limit profits will only have a limited effect on capping gas prices.

gasoline prices

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Five for Friday- Bucking The Trend

This week’s screen comes from a subscriber asking for a screen on stocks that “are bucking the trend.”  To help answer his request, we use both RSI and relative positioning versus moving averages to find stocks holding up well despite weakness in the broader markets.

Screen Criteria

  • RSI >80
  • Price above 20-, 50-, and 200-day moving averages
  • Positive YTD Performance

Scan Results

As we share below, the stocks in this scan are clearly bucking the trend this year. They have very overbought RSI levels and significant gains year to date. The companies are all relatively small, and four of the five are in the bio-sciences sector. As we warned last week, the stocks in this week’s scan have significant potential risks. That said, holders of these stocks have done very well for themselves this year.

Company Summaries (Corporate Summaries Courtesy of Zacks)

Turning Point Therapeutics (TPTX)

Turning Point Therapeutics is a clinical-stage biopharmaceutical company designing and developing novel small molecule, targeted oncology therapies to address key limitations of existing therapies and improve the lives of patients. Their internally developed and wholly owned pipeline of next-generation tyrosine kinase inhibitors (TKIs) targets numerous genetic drivers of cancer in both TKI-naive and TKI-pretreated patients. The pervasive challenges of intrinsic and acquired treatment resistance often limit the response rate and durability of existing therapies. One of these challenges is the emergence of solvent front mutations, which are a common cause of acquired resistance to currently approved therapies for ROS1, TRK and ALK kinases. They have developed a macrocycle platform enabling us to design proprietary small, compact TKIs with rigid three-dimensional structures that potentially bind to their targets with greater precision and affinity than other kinase inhibitors.

Sierra Oncology (SRRA)

Sierra Oncology, Inc. is a clinical-stage drug development company. It develops and markets drugs for the treatment of cancer. The product pipeline consists of SRA737 and SRA141. SRA737 is an orally bioavailable small molecule inhibitor of Checkpoint kinase 1, a key cell cycle checkpoint and central regulator of the DNA Damage Response network. SRA141 is an orally available small molecule inhibitor of cell division cycle 7kinase. Sierra Oncology, Inc., formerly known as ProNAi Therapeutics, Inc., is headquatered in Vancouver, Canada.

Permian Basin Royalty Trust (PBT)

PERMIAN BASIN ROYALTY TRUSTs principal assets are comprised of a 75% net overriding royalty interest carved out of Southland Royalty Company s fee mineral interests in the Waddell Ranch properties in Crane County, Tex. and a 95% net overriding royalty interest carved out of Southland Royalty Company s major producing royalty properties in Texas.

Arcellx (ACLX)

Arcellx Inc. is a biotechnology company reimagining cell therapy through the development of innovative immunotherapies for patients with cancer and other incurable diseases. Arcellx Inc. is based in GAITHERSBURG, Md.

Regencell BioScience Limited (RGC)

Regencell Bioscience Holdings Limited is an early-stage bioscience company which focuses on research, development and commercialization of Traditional Chinese Medicine for the treatment of neurocognitive disorders and degeneration, specifically Attention Deficit Hyperactivity Disorder and Autism Spectrum Disorder. Regencell Bioscience Holdings Limited is based in HONG KONG.

NFIB Signals A Recession Is Coming…Again

NFIB signals a recession is coming…again. The reason I say “again” is because, in September 2019, we discussed these same signals stating:

“Today, we once again see many of the early warnings. If you have been paying attention to the trend of the economic data, and the yield curve, the warnings are becoming more pronounced.

In 2007, the market warned of a recession 14-months in advance of the recognition. 

Today, you may not have as long as the economy is running at one-half the rate of growth.”

Of course, we now know the recession hit just 5-months later.

Today, we see many indications of economic risk, or as noted in “Economic Hurricane,” storm clouds are clearly on the horizon. To wit:

“The most recent CEO Confidence Index suggests that most leaders are concerned about the economy over the next few quarters.”

We also noted it wasn’t just the leaders of major corporations worrying about the state of the economy over the next few quarters. With inflation running above 8%, consumers are much less confident about their state of affairs.

The latest National Federation of Independent Businesses monthly Small Business Survey also supports the concern of an economic recession.

What Is The NFIB?

While the mainstream media overlooks the NFIB data, it really shouldn’t.

According to the U.S. Small Business Administration, there are 28.8 million small businesses in the United States, and they have 56.8 million employees. Small businesses (defined as businesses with fewer than 500 employees) account for 99.7% of all businesses in the U.S. The chart below shows the breakdown of firms and employment from the 2016 Census Bureau Data.

, NFIB Survey Trips Economic Alarms

Simply, small businesses drive the economy, employment, and wages. Therefore, what the NFIB says is highly relevant to what is happening in the actual economy versus the headline economic data from Government sources.

In April, the survey plunged to 93.2 from a pre-COVID high of 108.8. Historically, a reading below 100 is a recessionary warning.

NFIB Confidence Survey

It is also important to note that small business confidence is highly correlated to changes in, not surprisingly, small-capitalization stocks.

NFIB Survey vs Small Cap Stocks

The stock market and the NFIB signals risk are rising. As noted by the NFIB:

“Small business owners are struggling to deal with inflation pressures. The labor supply is not responding strongly to small businesses’ high wage offers and the impact of inflation has significantly disrupted business operations.”NFIB Chief Economist Bill Dunkelberg.

Sentiment Going Negative

Notably, the NFIB is a “sentiment” based survey like many surveys. Such is a crucial concept to understand.

“Planning” to do something is a far different factor than actually “doing” it.

For example, the survey stated that 20% of business owners are “planning” to increase employment in the next quarter. That sounds very positive until you look at the actual employment changes. In other words, “planning” to hire and committing to those costs are very different.

NFIB Employment plan vs actual

Such is especially the case when you compare their “plans” to the outlook for economic growth.

“Business investment” is a crucial component of the GDP calculation. Small business “plans” to make capital expenditures, which drive economic growth, have a high correlation with Real Gross Private Investment. While business investment remains elevated, it will decline as more firms opt to conserve cash as the economy slows.

CAPEX vs Real Private Investment

As I stated above, “expectations” are very fragile. The “uncertainty” arising from inflation, Russia/Ukraine war, and tighter monetary policy will weigh on business owners.

Economic Outlook Is Bleak

If small businesses were convinced that the economy was “actually” improving over the longer term, they would increase capital expenditure plans. However, the NFIB signals just the opposite.

The linkage between the economic outlook and CapEx plans is confirmation that business owners are concerned about committing capital in an uncertain environment. In other words, they may “say” they are hopeful about the “economy,” but they are just unwilling to ‘bet’ their capital on it.

Such is easy to see when you compare the survey’s economic outlook to economic growth. Not surprisingly, there is a high correlation between the two, given that business owners are the “boots on the ground” for the economy. Notably, their current outlook does not support the idea of more robust economic growth into year-end.

NFIB Economic improvement in 6-months

Of course, the Federal Reserve remains NO help in instilling confidence in small business owners to deploy capital into the economy. As NFIB’s Chief Economist Bill Dunkleberg stated:

“The Fed announced a rate hike of half a point this month with more hikes to come in future meetings. Under Paul Volcker, the Fed’s rate hit 20 percent, a long way from where we are today. If, historically, the Fed’s rate needs to be above inflation to be effective, we have a long way to go and the Fed is way behind the curve.”

Fantasy Vs. Reality

That certainly isn’t going to convince small business owners to commit capital, particularly when they are already concerned about a recession.

“Predictions have a recession starting as early as the third quarter of this year, although most guesses have 2023 for the start. Owners are very pessimistic about sales and business conditions in the second half of the year. This dampens capital investment and, eventually, will feed into employment if sales actually slow as expected.” – NFIB

As noted above, the gap between owners’ employment expectations and hiring continues to fall. That divergence between expectations and reality can also get seen in actual sales versus expectations of increased sales. 

Employers do not hire just for the sake of hiring. Employees are one of the highest costs associated with any enterprise. Therefore, hiring takes place when there is an expectation of increased demand for a company’s product or services. 

NFIB sales expectations vs actual sales

Furthermore, the decline in actual and expected sales corresponds with the reversion of real retail sales as consumers slow consumption due to surging inflation.

NIFIB actual vs retail sales

Lastly, despite hopes of continued debt-driven consumption, business owners face actual sales at levels more generally associated with the onset of a recession.

With small business optimism waning currently, combined with many broader economic measures, it is not surprising the NFIB signals many owners are worried about a recession.

No Recession In Sight?

It is readily apparent that “recession” risks are rising. One of the best leading indicators of a recession is “labor costs,” which, as discussed in the report on “Cost & Consequences Of $15/hr Wages,” is the highest cost to any business.

When those costs become onerous, businesses raise prices, consumers stop buying, and a recession sets in. So, what does this chart tell you?

NFIB Labor Costs

Don’t ignore the data.

We again see many of the early warning signs of an economic downturn. While such doesn’t guarantee a recession, it does suggest the risks of an economic downturn are markedly higher.

As noted above, in 2007, the market warned of a recession 14-months in advance of the recognition. In 2019, it was just 5-months.

No one knows the timing of the recognition of the next recession. However, with economic growth slowing, the Fed hiking rates, and inflation weighing on consumers, I suspect we are closer than many think.

The last time the NFIB Signals were this weak, the Government started sending checks to households, and the Fed introduced $120 billion in monthly “QE.” Furthermore, interest rates fell to 0.5% as the Fed scrambled to buy junk bond ETFs.

I wonder how much longer the Fed will keep playing a “game of chicken” with the markets before one of them blinks.

My suspicion is the Fed will eventually cave.

75bps Of Shock and Awe Calms Markets

While the WSJ telegraphed the potential for a 75bps rate hike on Tuesday, the Fed’s decision to raise the Fed Funds rate by 75bps to 1.50% at yesterday’s FOMC meeting shocked many investors. 75bps is the largest rate hike since 1994. The Fed now expects to raise Fed Funds by another 2% by year-end. The driving force behind the Fed’s aggressive 75bps rate hike was its upward revision to its year-end inflation (PCE) expectation (from 4.3% to 5.2%).

Per the statement: “The Committee is strongly committed to returning inflation to its 2% objective.” The Fed seems to have an optimistic prognosis for economic activity. They said: “Overall economic activity appears to have picked up after edging down in the first quarter.” Paradoxically, the statement came two hours after the Atlanta Fed GDPNow revised its second-quarter growth estimate to 0.0%.

Stocks and bonds took solace in the Fed’s commitment to fighting inflation. The S&P 500 rose about 1.5%, and Treasury bond yields fell by about 20bps. The “red lined” FOMC statement below shows the changes in the Fed’s position since the last meeting.

fed statement 75bps

What To Watch Today

Economy

  • 8:30 a.m. ET: Housing Starts, May (1.696 mil expected, 1.724 mil prior, revised to 1.823 mil)
  • 8:30 a.m. ET: Building Permits, May (1.780 mil expected, 1.819 mil prior, revised to 1.823 mil)
  • 8:30 a.m. ET: Housing Starts, MoM, May (-1.6% expected, -0.2% prior, revised to -3.0%)
  • 8:30 a.m. ET: Building Permits, MoM, May (-2.4% expected, -3.2% prior, revised to -3.0%)
  • 8:30 a.m. ET: Philadelphia Fed Business Outlook Index, June (5.0 expected, 2.6 prior)
  • 8:30 a.m. ET: Initial jobless claims, week ended June 11 (217,000 expected, 229,000 prior)

Earnings

Pre-market

  • Kroger (KR) to report adjusted earnings of $1.30 on revenue of $44.09 billion
  • Jabil (JBL) to report adjusted earnings of $1.62 on revenue of $8.23 billion

‌Post-market

  • Adobe (ADBE) to report adjusted earnings of $3.31 on revenue of $4.35 billion

Market Trades On Fed Announcement, Time For A Rally?

Yesterday, the market widely expected the 75bps hike from the Federal Reserve. The waterfall selloff over the last several days was pricing that in. With the rate hike now behind us and the market trading to the bottom of its current downtrend, the question is whether traders can muster a rally. The market is oversold enough to support that, but the MACD has triggered a fresh sell signal.

This morning futures are sharply lower as the reality of a recession is sinking in. However, any rally that does occur will be a “relief rally” to be sold into as there are still many trapped longs looking for an exit, especially after the recent drop. Caution remains advised.

Stock market update, time for a rally?

An Earnings Recession Is Coming

We penned an exclusive article for MarketWatch which was published yesterday.

“Of course, since earnings are highly correlated to economic growth, earnings don’t survive rate hikes. As the arrows below show, Fed rate increases consistently lead to earnings recessions.”

Read the full article here.

https://www.marketwatch.com/story/the-fed-is-aggressively-raising-interest-rates-an-earnings-recession-comes-next-11655327367

The Fed Is Still TOO Optimistic About Economic Growth

The Federal Reserve regularly releases its economic projections for each quarter. The only thing they are good for is to remind ourselves the Federal Reserve members are the worst economic forecasters on the planet. As shown, just since the release of their last projections, their view has dropped sharply. In fact, going back in history, they have never accurately forecasted economic activity since they started this exercise in 2011.

Regardless, their current views of economic growth for the rest of 2022 remain too elevated as a recession quickly approaches.

Visualizing The Fed’s Trap

To understand why the Fed hiked by 75bps and plans on continuing aggressive monetary tightening, the graph below helps visualize its problem. Over the last 20 years, the Fed has been predominately focused on maximizing its full employment mandate. They had little need to worry about inflation. That allowed for easy monetary policy more often than not. Today, however, they have the opposite problem. They must sacrifice employment to temper inflation. Such a goal requires hawkish policy. The graph below shows the current situation (yellow dots) is far different than the last 20 years.

fed mandate employment cpi

Retail Sales, Empire State Index, and Import Prices

Retail sales were disappointing, coming in at -.3% versus expectations for a slight gain. But, making matters worse, the number is nominal, not inflation-adjusted. CPI was +1% in May, meaning that retail sales fell by 1.3% on an inflation-adjusted basis. The control group retail sales figure, which directly feeds GDP, was flat. The graph below shows that more money is being spent on necessities like gas and food and less on discretionary goods.

retail sales inflation

The Fed’s Empire State Manufacturing Index remains in economic contraction territory but improved from last month. Yesterday’s negative reading was the fourth this year. While the index is solely for New York, the Fed’s regional indexes have an excellent track record of predicting national economic activity.

Unlike the Empire Index and Retail Sales, the Import Prices Index provided good news. Import Prices excluding fuel fell by 0.3%. It was the first decline since 2020. As shown below, the 3-month index is falling rapidly, and the year over year is beginning to turn lower. No doubt, dollar strength is helping this price gauge.

import prices inflation

Corporate Profits, Inflation, Confidence, and S&P 2500

Wall Street has yet to materially downgrade corporate profits forecasts. However, the economy is slowing rapidly, and many personal and business confidence indicators are falling rapidly. The first graph below from Callum Thomas shows the strong correlation between confidence and earnings. His commentary refers to the second chart showing the strong correlation between falling P/E ratios and higher inflation. Putting the graphs together allows us to form expectations on where the S&P 500 might go based on inflation and P/E. The S&P 500’s P/E is approximately 20. If inflation drops to 4%, the P/E ratio falls to 15 (second graph), and earnings fall 10% (first graph), the S&P would need to fall to approximately 2500!

corporate profits p/e
S&P 500 p/e

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Inflation Expectations Are Flat- What Gives?

The graph below shows that 5yr yields have risen over 2% in 2022. Many in the media ascribe the yield surge to rising inflation expectations. However, as we offer below, two well-followed measures of 5-year inflation expectations have been relatively flat for the last few months. The question then is, what gives?

First, with many risk assets falling in price, liquidity is required to meet margin calls. Treasury securities are the world’s most liquid assets, and its likely investors may be selling them to meet such demands. Second, the Bank of Japan (BOJ) has capped the yield on its 10-year note at .25%. To defend the cap, the bank must buy its bonds whenever the yield approaches .25%. Such actions typically pressure the yen lower. Might the BOJ be selling Treasury bonds to provide the means to buy their notes and to keep the yen from falling further? The yen is down 15% year to date.

5 year inflation expecations

What To Watch Today

Economy

  • 7:00 a.m. ET: MBA Mortgage Applications, week ended June 10 (-6.5% prior)
  • 8:30 a.m. ET: Empire Manufacturing, June (2.5 expected, -11.6 prior)
  • 8:30 a.m. ET: Retail Sales Advance, month-over-month, May (0.1% expected, 0.9% prior)
  • 8:30 a.m. ET: Retail Sales excluding autos and gas, MoM, May (0.4% expected, 1.0% prior)
  • 8:30 a.m. ET: Import Price Index, MoM, May (1.1% expected, 0.0% prior)
  • 8:30 a.m. ET: Import Price Index excluding petroleum, MoM, May (0.6% expected, 0.4% prior)
  • 8:30 a.m. ET: Import Price Index, year-over-year, May (11.9% expected, 12% prior)
  • 8:30 a.m. ET: Export Price Index, month-over-month, May (1.3% expected, 0.6% prior)
  • 8:30 a.m. ET: Export Price Index, year-over-year, May (18.0% prior)
  • 10:00 a.m. ET: Business Inventories, April (1.2% expected, 2.0% prior)
  • 10:00 a.m. ET: NAHB Housing Market Index, June (67 expected, 69 prior)
  • 2:00 p.m. ET: FOMC Rate Decision, lower bound, June 15 (1.25% expected, 0.75% prior)
  • 2:00 p.m. ET: FOMC Rate Decision, higher bound, June 15 (1.50% expected, 1.00% prior)
  • 2:00 p.m. ET: Interest on Reserve Balances Rate, June 16 (1.40% expected, 0.90% prior)

Earnings

Pre-market

  • No notable companies are expected to report.

‌Post-market

  • No notable companies are expected to report.

Market Struggles To Find Footing

Yesterday, the market struggled to find some footing ahead of the FOMC meeting announcement this afternoon. Notably, the waterfall decline since last Thursday put the markets back into a deep, weekly oversold condition. While inflation expectations remain muted, the markets are pricing in more aggressive Fed rate hikes.

Yesterday, we covered half of our short-S&P 500 ETF position for this reason as a short-term bounce is likely. While the forward outlook for the market remains weak as the Fed tightens policy, fairly strong rallies should be expected to previous levels of resistance. Currently, our target for a short-term rally is roughly 4000 but a retracement to 4400 on the S&P 500 index is possible.

Market Trading Update

Fed Preview

What we thought would be a “boring” Fed meeting today may be anything but that. While implied inflation expectations are reasonably stable, Fed concerns about inflation seem to be rising. Recent articles from Nick Timiraos (WSJ), often a source of intentional Fed leaks, wrote on Monday about the potential for a 75bps rate hike. Wall Street seems to be getting behind that idea as well, with many banks forecasting a 75bps increase. So what happens to stocks and bonds if they only go 50 or raise by 75?

Our question is tough to answer. If the Fed only goes 50, stock investors may breathe a sigh of relief, but bond investors may worry as the Fed is not vigilant enough on inflation. Higher yields may likely, in that case, translate to lower stock prices in time. If they go 75, bonds may rally, but stock investors may fret that such aggressive action will ensure a recession. That said, stock investors may applaud 75 as the Fed wants to tackle inflation sooner rather than later. As you can tell by the array of outcomes, it is anyone’s guess. Further complicating the matter is a massive options expiration on Friday. It is quite likely the Fed meeting will usher in volatility through the remainder of the week.

90% Of Tech Stocks Are In A Bear Market

“For only the second time in more than a decade, the number of Technology stocks in a bear market exceeded 90%. Several cases like 2007-08, 2000-02, 1973-74, and 1968-70 maintained a high level of stocks in a bear market for a significant amount of time, especially 2000-02.” – Sentiment Trader

tech stocks in a bear market

Dollar is Surging

The graph below shows the dollar index has been on a tear over the last year. Since May 2021, the index is up over 15%. The appreciation is primarily a function of the Fed’s hawkish monetary policy and the relative dovishness of other large central banks. The ECB, for instance, is just starting to raise rates and will not embark on QT. The BOJ is still one of the rare dovish central banks left. While the difference in monetary policy may remain, the dollar may not strengthen further. An appreciating dollar is bad for exports and encourages imports, weighing U.S. corporate profits. A stronger dollar will help keep import prices down, which may help temper inflation. Conversely, Europe and Japan can ill afford more inflation and may likely step in to arrest the decline in their currencies.

dollar usd

Small Businesses Outlook Worst in 48 Years

As we discussed last week, the University of Michigan Consumer Sentiment Expectations Index sits just shy of 80-year lows. The most recent NFIB Survey paints a similar picture about the expectations of small business owners. The NFIB Index is falling and now sits at 5-year lows, but the NFIB expectations index is plummeting. Per the Report:

The NFIB Optimism Index fell 0.1 points in May to 93.1, marking the fifth consecutive month below the 48-year average of 98. Owners expecting better business conditions over the next six months decreased four points to a net negative 54%, the lowest level recorded in the 48-year-old survey. Expectations for better business conditions have deteriorated every month since January.

small business outlook

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Are Financial and Market Instability The Last Hopes For Stocks

The Federal Reserve’s Congressionally chartered dual mandates are price stability and maximum sustainable employment. These objectives are intended to dictate monetary policy and the Fed’s longer-run goals and strategies. Recent experience, however, asserts that preventing financial and market instability trumps Congressional decree.

The illustration below from the Federal Reserve Bank of Chicago helps visualize its mandates. The “Dual Mandate Bullseye” highlights its 2% core inflation rate and 4.1% unemployment rate objectives.

dual mandate bullseye

The Fed is currently way off the mark. As we share below, core CPI is running about 4% above the Fed’s target, and the unemployment rate is about half a percent below their objective.

fed dual mandate

To address surging inflation, the Fed is taking aggressive actions which might increase joblessness and slow the economy but hopefully reduce inflation.

Higher interest rates and balance sheet reduction (QT) are not good for stock prices. Investors need to consider how much pain the Fed is willing to inflict on stock prices to hit their bullseye. Further, besides significantly lower inflation or a surge in the unemployment rate, what might allow the Fed to deviate from its objectives and save stock prices?

We present the Fed’s third self-imposed objective, preventing financial and market instability.

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History Of The Third Objective

As the “bankers’ bank,” the Fed has made it clear through its actions that monetary policy will also be used to maintain financial and market stability and protect the financial sector. Financial and market stability encompasses the healthy functioning of capital markets. Many times in the past, when financial markets became illiquid and stressed, or even as instability appeared imminent, the Fed has come to the rescue with liquidity.

One only needs to look back to 2019. In August 2019, the Fed lowered the Fed Funds rate, restarted QE, and offered institutional investors liquidity through repo transactions.

Then, the unemployment rate was 3.7%, .4% below its target. Core PCE, the Fed’s preferred inflation measure, was 1.85%, .15% below their target. The Fed was easing. Given their mandates, the Fed should have been tightening monetary policy.  

Rather than forcing some investors to deleverage, which could destabilize markets, they provided liquidity. The Fed tossed its congressionally mandated objectives out the window. Instead, protecting large investors and preventing financial and market instability took precedence.  

The Fed Put

Over time, financial instability has become the beacon call for Fed action. In many investors’ minds, financial instability is not just about helping financial institutions in need but also arresting falling stock prices. Such a Fed reaction is often referred to as the Fed Put.    

The Fed’s influence, directly, indirectly, and in investor mindset, has increasingly resulted in a positive correlation between stock market returns and Fed policy. When monetary policy is easy, stock prices and valuations tend to rise. Conversely, when the Fed tightens policy, stocks tend to exhibit weakness.

With a very hawkish Fed pushing interest rates higher and embarking on an aggressive QT program, the Fed’s third objective may be investors’ only hope for the Fed to stop the market bleeding.

Fed Funds and Leverage

The Fed graph below shows the Fed has used an abnormally low Fed Funds rate to help fuel debt-driven growth. Fed Funds should trade at or above the inflation rate. When Fed Funds are below the rate of inflation, as it has been for the last 20 years, it implies the Fed is pushing rates below where economic conditions and a free market would justify.

fed funds cpi inflation

Financial instability increases as the real Fed Funds rate become positive. The reason is that too much financial/speculative leverage relies on low rates. As rates rise, liquidity fades, and leverage must be reduced. Consider the brief period when real Fed Funds were positive in 2019 and the “financial instability” that ensued. 2006 and 2007 is another example.

The Fed does not solely pay attention to Fed Funds or Treasury Yields to measure stability. They also concern themselves with corporate borrowing rates. In particular, the spread between corporate borrowing rates and Treasury yields. The wider the spread, the more illiquid market conditions for corporate borrowing. Illiquid market conditions can result in bankruptcy, as we saw in 2008.

Corporate and Bank Yield Spreads

Below we share a few popular bond market measurements to assess where corporate bond and bank yield spreads are today versus historical spreads.

The graph below shows that the spreads of BBB- and B-rated corporate debt yields versus the same maturity Treasury yields are elevated. However, the current spreads pale compared to those seen in 2008 and other liquidity events. While the corporate bond market spreads can widen quickly, those sectors do not have a financial stability problem today.

corporate bond spreads

The TED Spread or Treasury Eurodollar spread measures the cost of borrowing dollars for foreign banks versus Treasury yields. Like the corporate bond spread analysis, widening spreads can be a precursor to potential liquidity issues.

As shown below, the spread was recently at its widest level since the Financial Crisis. Since then, it has tightened. Like many other financial stability measures, the TED spread is higher than normal but not close to concerning levels. 

ted spread

Equity Volatility

The Fed Put is the market’s way of saying the Fed has the market’s back if it falls enough. “Enough” is often considered a loss of between 10 and 20%.

In Liquidity and Volatility- Decoding Market Jargon, we state:

More importantly, volatility is not just a mathematical calculation. Volatility measures liquidity! And liquidity defines risk.

In illiquid markets, price swings tend to be extreme and often result in financial instability. Accordingly, we compare current implied and realized volatility levels to historical readings.

Realized, or historical, volatility is backward-looking. It is a statistical measure of an asset’s price movement over a prior period.

Implied volatility is derived from options prices. It gauges what investors think volatility will be in the future.

The graph below shows annual and implied volatility is high but well below levels seen during the Financial Crisis and the initial days of the pandemic. Currently, both levels are only one standard deviation extended from their norms. A variation of three or more standard deviations would likely be destabilizing.

volatility

Summary

We can measure financial stability in many ways. The more popular ones we highlight show financial instability is not a current problem.

However, like summer thunderstorms, financial instability can pop up quickly and cause significant damage. We are hearing that there are some liquidity concerns in the mortgage and short-term Treasury markets. So, while the traditional measures of instability may not be alarming, we need to stay alert as liquidity problems spread quickly.

It is crucial to keep in mind the threshold for a Fed “instability” U-turn is much higher than in the past. Given the stubbornness of the recent bout of inflation, the economic damage it’s inflicting on much of the population, and growing political pressures, the Fed will not be able to react quickly to premonitions about financial instability. Unless inflation quickly diminishes, it will tolerate a higher-than-normal amount of instability. Such may likely result in higher bond spreads and lower stock prices.

Portfolio Trade Alert – June 14, 2022

Trade Alert For Equity & ETF Model

This morning we reduced our S&P 500 Short position by 50% for a couple of reasons:

  1. The market is very oversold on a short-term basis and could bounce on any surprise comments from the Fed tomorrow.
  2. We are holding a lot of cash after the sales we made yesterday, so reducing the hedge a bit here doesn’t change our downside protection much but will allow the portfolio to participate a bit better during a potential bounce.

We sold the position with a small gain after yesterday’s decline. Therefore, we don’t have to worry about wash sale rules to add it back to the model on any bounce over the next few days.

Both Models

  • Sell 50% of the S&P 500 Short ETF (SH)

2yr Treasury Yields Soar

The graph below shows that 2yr Treasury yields rose 0.25% on Friday, the largest one-day change since 2009. On May 31, 2022, the 2yr Treasury yield was 2.54. Today the 2yr Treasury yield is approaching 3.35%. The bond market, especially the shorter maturities, is increasingly concerned that the Fed may raise rates by .75bps at tomorrow’s meeting and/or the one in July. Last Friday’s CPI report appears to be responsible for this disorderly sell-off.

For a brief moment on Monday morning, the 2yr Treasury yield curve was flat. Since then, it steepened but remains close to inverting. As we have noted, a yield curve inversion typically precedes a recession. However, the recession starts after the curve steepens out of an inverted state.

2yr treasury yield

What To Watch Today

Economy

  • NFIB Small Business Optimism, May (93.0 expected, 93.2 during prior month)
  • PPI final demand, month-over-month, May (0.8% expected, 0.5% during prior month)
  • PPI final demand, year-over-year, May (10.8% expected, 11.0% during prior month)

Earnings

Pre-market

  • Core & Main (CNM) to report adjusted earnings of 35 cents on revenue of $1.38 billion

Post-market

  • Sprinklr (CXM) to report adjusted losses of 6 cents on revenue of $141.00 million

Market Tanks As Support Is Taken Out

The market tanked yesterday as the 2yr Treasury Yield soared spooking markets the Fed might be even more aggressive on Wednesday and hike 0.75%. More on that next. Technically, the market broke previous support lows and collapsed back to the previous market bottoms in early 2021 erasing the entirety of last year’s gains. With the market back on a MACD sell signal, there is a risk of more downward pressure. However, with the market short-term oversold and more than 2-standard deviations below the 50 dma, a bounce following the Fed meeting will not be surprising.

We will look to use bounces to add to our short-position further and reduce additional equity risk as needed.

Fed Meeting On Wednesday – .50% or 0.75% Bps?

“A string of troubling inflation reports in recent days is likely to lead Federal Reserve officials to consider surprising markets with a larger-than-expected 0.75-percentage-point interest rate increase at their meeting this week.

Before officials began their pre-meeting quiet period on June 4, they had signaled they were prepared to raise interest rates by a half percentage point this week and again at their meeting in July. But they also had said their outlook depended on the economy evolving as they expected. Last week’s inflation report from the Labor Department showed a bigger jump in prices in May than officials had anticipated.

Two consumer surveys have also shown households’ expectations of future inflation have increased in recent days. That data could alarm Fed officials because they believe such expectations can be self-fulfilling.” – Nick Timiraos

That potential for a 0.75% hike sent the 2yr Treasury Yields surging, nearly inverted the yield curve, and then crushed the long-end.

Healthcare on Critical Support

The graph and commentary below come from a feature we do in SimpleVisor every Monday. Yesterday’s Market Sector Buy-Sell Review shows that XLV (healthcare) is sitting on critical support. Many other sectors have similar-looking graphs and, as such, are in similar predicaments. Per the commentary:

  • So goes the economy, so goes transportation. As the economy is showing signs of slowing, Transportation has come under pressure, adding to downward pressure from a declining 50-dma.
  • Currently, the sell signal has triggered and is adding to the downward pressure. (bottom panel)
  • Transportation is approaching oversold on a short-term basis. (top panel)
  • Short-Term Positioning: Bearish
    • Sell current positions on any rally to $75-78
    • Stop-loss is currently broken.
  • Long-Term Positioning: Bearish
xlv healthcare

Financial Instability

Price stability and maximum sustainable employment are the Federal Reserve’s Congressionally chartered dual mandates. These objectives are supposed to dictate monetary policy and the Fed’s longer-run goals and strategies. Recent experiences, however, assert that financial instability trumps Congress’s mandates. Given that inflation is surging and the unemployment rate is below average, will financial instability cause the Fed to reverse its hawkish tone?

The graph below says not yet. The orange line shows that IEI, the 3-7 year UST ETF, has fallen almost 10% since the start of the year. Over this period, the 5-year yield has risen from .75% to nearly 3.25%. Typically such a sharp increase in yields would trouble the credit markets. The graph below shows that is not the case. The ratio of the price of JNK to LQD (junk to investment-grade corporate bonds) has been relatively stable. In fact, JNK has slightly outperformed over the last few days despite yields rising appreciably. This one measure of financial stability shows no signs of problems.

junk bonds, instability, iei

Cass Uses The “D” Word

Cass Systems helps companies manage freight/logistic expenses. They also put out a well-followed index on global freight costs. Per Cass, the demand-supply imbalance over the last year has resulted in soaring shipping costs, as we share below. This may be coming to an end, and per Cass, deflation in shipping costs is coming.

After nearly a two-year cycle of surging freight volumes, two key drivers of growth for the freight cycle– goods consumption and inventory restocking are faltering. Combined with a major improvement in driver availability (27,300 new jobs added in the past two months), all signs continue to point to a change in the trajectory of (shipping) rates in the coming months.

While this is welcome news on the inflation front, it does point to much slower economic growth ahead.

cass freight index

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“Economic Hurricane” – Hyperbole Or Real Possibility?

An “economic hurricane” is coming. That ominous warning comes from Jamie Dimon, CEO of J.P. Morgan Chase.

“I said there were storm clouds. But I’m going to change it. It’s a hurricane. Right now it’s kind of sunny, things are doing fine, and everyone thinks the Fed can handle it. That hurricane is right out there down the road coming our way. We don’t know if it’s a minor one or Superstorm Sandy. You better brace yourself.”

Of course, he isn’t the only CEO feeling this way. The most recent CEO Confidence Index suggests that most leaders are concerned about the economy over the next few quarters.

CEO Confidence survey

Adding to that, the NFIB Small Business Survey also suggests that the economic backdrop is deteriorating rapidly. The chart below shows the number of firms expecting an economic improvement over the next 6-months. That number plunged to the lowest reading ever.

NFIB Economic outlook

Of course, businesses are gloomy because consumer confidence, which is where they derive their revenue and profits, suggests dismal growth ahead. Our consumer confidence composite index (UofM and Conference Board measures) of expectations less current conditions is already at levels associated with previous bear markets and corrections.

So, is Jamie Dimon being hyperbolic, or is there a genuine concern for an economic hurricane?

The Storm Clouds Are Closer Than They Appear

Dimon’s two primary concerns about the economy are valid – the risk of a Fed policy mistake and the war between Russia and Ukraine. I am personally concerned about the first risk more than the second.

An honest review of history shows the Fed is consistently a “day late and a dollar short” regarding monetary policy. The history of “financial accidents” due to the Fed’s monetary intervention schemes is evident. Not just over the last decade, but since the Fed became “active” in 1980.

Fed rates economic growth crisis events

What should be evident is that before the Fed became active, economic growth was accelerating. There were few crisis events, and economic prosperity was broad. However, post-1980, the trend of economic growth declined. There are many reasons leading up to each event. However, the common denominator is the Fed tightening monetary policy.

Notably, Fed rate hiking campaigns correlate with poor financial market outcomes, as higher rates impacted the credit and leverage markets.

Fed reserve rate hikes, market events and crisis.

Such is where I agree with Dimon considering his comments on monetary policy.

“We’ve never had QT like this, so you’re looking at something you could be writing history books on for 50 years,”

When the Fed reduced its balance sheet in 2018, it ran at a pace of $30 billion monthly with very low inflation. Starting this month, the Fed will be ramping up that reduction to 3-times the previous run rate, with inflation at nearly 9%.

Fed balance sheet taper vs market.

While they believe they can achieve this reduction without disrupting the equity markets or causing an economic contraction, history suggests otherwise.

The Russia/Ukraine conflict, rising interest rates, and soaring commodity costs exacerbate the collapse in confidence. Such has already significantly tightened monetary policy, elevating the risk that the Fed will again make a “policy mistake.

Preparing For An Economic Hurricane

From our perspective, I had often disagreed with Mr. Dimon’s outlooks (see here), like in December 2019 when he stated:

This is the most prosperous economy the world has ever seen. It’s going to be a very prosperous economy for the next 100 years.” – Jamie Dimon

That statement didn’t age well. Just 3-months later, the economy plunged into the deepest recession since the “Great Depression.”

However, this time I don’t. The risk of an “economic hurricane” is certainly elevated. But as someone who grew up on the Gulf Coast, Hurricanes can be unpredictable. More than once, my Dad and I boarded up windows and stocked up on non-perishable food and water, only to see the storm change course at the last minute. However, the preparation, while wasted, was better than the alternative.

Between soaring inflation, falling wages, slowing economic growth, and a Fed bent on tightening monetary policy, there is a storm on the horizon. The magnitude, timing, and location of the “economic hurricane” are still anyone’s best guess.

All we can do is prepare for the storm and then cross our fingers and hope for the best. The guidelines are simplistic but ultimately effective.

  1. Raise cash levels in portfolios
  2. Reduce equity risk, particularly in high beta growth areas.
  3. Add or increase the duration in bond allocations which tend to offset risk during quantitative tightening cycles.
  4. Reduce exposure to commodities and inflation plays as economic growth slows.

If the hurricane hits, preparing for the storm in advance will allow you to survive the impact. It is a relatively straightforward process to reallocate funds to equity risk if it doesn’t.

Given the numerous shocks to the system happening concurrently, I think investors will need more than just an umbrella to survive it.

Viking Analytics: Weekly Gamma Band Update 6/13/2022

We share the Weekly Gamma Bands Update by Viking Analytics. The report uses options gamma to help you better manage risk and your equity allocations.

The S&P 500 (SPX) fell sharply on Thursday and Friday, and closed near the lows on both days. This price action should be concerning for bulls as we head into the important mid-year option expiration week. The prior two major sell-offs (in Dec 2018 and March 2020) climaxed in and around a quarterly option expiration cycle. This market continues to be in an amplified “buy the rip” and “sell the dip” mode under the gamma flip level near 4,180.  Our gamma band model enters the week with a 30% allocation to the SPX and will move to 0% allocation on a close below 3,865.  

The Gamma Band model[1] can be viewed as a trend following model that is shows the effectiveness of tracking various “gamma” levels. When the daily price closes below Gamma Flip level, the model will reduce exposure to avoid price volatility and sell-off risk. If the market closes below what we call the “lower gamma level,” the model will reduce the SPX allocation to zero.

The main premise of this model is to maintain high allocations to stocks when risk and corresponding volatility are expected to be low.  For investors who have been conditioned to “buy low and sell high,” it is counter-intuitive to increase allocations when the market rises, but this approach has shown to increase risk-adjusted returns in the back-test.  

Risk management tools like this have become more important than ever to manage the next big drawdown. We incorporate many options-based signals into our daily stock market algorithms. Please visit our website to learn more about our trading and investing tools.

The Gamma Band model is one of several indicators that we publish daily in our SPX Report (click here for a sample report). 

The Gamma Flip – Background

Many market analysts have noted that daily volatility in the S&P 500 will change when the value of the SPX moves from one gamma regime to another.   Some analysts call this level the “gamma flip.”  The scatterplot below shows how price volatility (on the y-axis) is increasingly lower as the value of SPX rises higher above the Gamma Neutral level (on the right side of the chart).  When the value of the S&P closes lower than Gamma Neutral (to the left of the chart), volatility increases. 

Gamma Band Model – Background

The purpose of the Gamma Band model is to show how tail risk can be reduced by following a few simple rules.  The daily Gamma Band model has improved risk-adjusted returns by over 60% since 2007.  The graph below demonstrates how this approach can limit drawdowns while maintaining good returns.  A quick video introduction of the Gamma Band model can be seen by following this link

Disclaimer

This is for informational purposes only and is not trading advice.  The information contained in this article is subject to our full disclaimer on our website.

[1] The Gamma Band model in our SPX Market Report adjusts position size DAILY based upon the daily closing levels of SPX value and calculated Gamma Neutral.  The Weekly Gamma Band model is shown for illustrative purposes only.

Authors

Erik Lytikainen, the founder of Viking Analytics, has over twenty-five years of experience as a financial analyst, entrepreneur, business developer, and commodity trader. Erik holds an MBA from the University of Maryland and a BS in Mechanical Engineering from Virginia Tech.

Rob McBride has 15+ years of experience in the systematic investment space and is a former Managing Director at a multi-billion dollar hedge fund. Rob has deep experience with market data, software and model building in financial markets.  Rob has a M.S. in Computer Science from the South Dakota School of Mines and Technology.


TPA-RRG Report (relative rotation graph scores and rankings)

Click either image below for the entire report.

Portfolio Trade Alert – June 13, 2022

Trade Alert For Equity & ETF Models

As noted in the Market Sector Buy/Sell Review this morning, there are several areas of the market breaking key supports, along with the S&P index taking out support and triggering a MACD sell signal. While we have been raising cash and hedging risk over the last two weeks, we are taking further actions to cut exposure heading into the Fed meeting on Wednesday and options expiration on Friday.

Note: We added to the S&P 500 Short (SH) today but may take it back off at the end of the day if markets finish near lows. With the market down nearly 10% in 3-days, a bounce to add it to portfolios is likely.

Equity Model

  • Selling 100% of AMD (AMD), Nvidia (NVDA), Ford (F), and Goldman Sachs (GS)
  • Selling 100% of IEF to prepare for adding to TLT to lengthen bond duration.
  • Increase S&P 500 Short (SH) to 5% of the portfolio.

ETF Model

  • Reducing SPDR Financials ETF (XLF) from 3% to 1%
  • Cutting SPDR Real Estate ETF (XLRE) from 2.5% to 1.5%
  • Reducing SPDR Technology ETF (XLK) from 8% to 6%.
  • Selling down SPDR Healthcare ETF (XLV) from 9% to 8%.
  • Selling 100% of IEF to prepare for adding to TLT to lengthen bond duration.
  • Increasing S&P 500 Short (SH) to 5% of the portfolio.

THIS WEEK’S TOP 10 BUYS AND TOP 10 SELLS – Monday, June 13, 2022

Click the image below for the entire report with charts

Major Sector Buy/Sell Report

We have posted our latest report on the major S&P 500 sectors with buy/sell levels and a technical overview.

FIND IT HERE

CPI – Onward and Upward

The BLS CPI Inflation report surprised the markets, coming in hotter than expected. The surprises were in the monthly and annual CPI numbers, as shown below. Interestingly, however, the core CPI data, which excludes food and energy, was in line with expectations and lower for the second month in a row. The Fed prefers core inflation data as it views food and energy prices as volatile and not representative of longer-term inflation trends. Below are a few key statistics worth sharing.

  • 71% of the items in the CPI report are increasing at an annualized rate of 4% or greater.
  • Real wages are now falling by 3% and have been negative for 14 months running.
  • The lower-income classes are suffering as necessities like food, energy, and shelter led the CPI index higher.
  • Shelter represents about a third of the CPI number and is now up 5.5% yearly. It still pales in comparison to other rent and home price measures.
  • Used car prices are retreating. They are now up 16.1 annually versus a high of 45% six months ago.

Bottom line: inflation is stubborn, and the Fed has no choice but to hike rates by at least 50bps next week and in July. A stall in September is very unlikely.

cpi inflation

What To Watch Today

Economy

  • No notable reports are expected for release.

Earnings

Pre-market

  • No notable earnings are expected for release. 

Post-market

  • Oracle (ORCL) to report $1.37 in profits with revenue growth of 7% per share.

Market Fails At Important Resistance

Last week, we discussed how the reflexive rally that started mid-May ran into resistance at the first levels from the recent low. To wit:

“While the market did clear the 20-dma, the “trapped longs” headed to the exits at the initial 38.2% Fibonacci retracement level from the March highs. That level was also where previous important support for the February and April lows got broken.”

Rally Fails, Rally Fails As Recession Risks Rise

Unfortunately, the rally failed as recession risks from continued high inflation became evident.

We previously reviewed the market’s technical backdrop from a bullish and bearish perspective. While the short-term backdrop favored the bulls, the longer-term signals were bearish. Adding to the bearish backdrop is the tighter Fed policy and the reduction of market support as “quantitative tightening” begins.

Rally Fails, Rally Fails As Recession Risks Rise

Furthermore, the economic backdrop of high inflation and slowing economic growth certainly doesn’t give the bulls much to work with.

As shown above, our concern was that the longer the market remained in a tight trading range, the risk of a failed rally increased. While there was certainly room for the market to break to the upside, the multiple levels of resistance immediately overhead limited any advance. The failed rally now adds additional downward pressure on prices near term.

Therefore, from a risk management perspective, we continue to suggest using rallies to reduce exposure and raise cash. Given the failed rally, it is important the retest of the previous lows holds. A break of those lows will confirm the “bear market” is fully engaged.

The Week Ahead

The week ahead should be interesting. We get a break from data on Monday. On Tuesday, the BLS will release producer prices (PPI). Expectations are for an increase from last month. Wednesday features retail sales, which are expected to rise by .3%. While positive, such a reading is negative .7% when adjusted for the latest CPI report. At 2 pm, the Fed will release the statement from its FOMC meeting and new economic projections. Jerome Powell will follow it up with a press conference at 2:30.

Given Friday’s CPI report, we believe the Fed will hike rates by 50bps and continue with very hawkish rhetoric. The only possible surprise would be a decision to hike rates by 75bps or discuss it as a possibility for the late July meeting. Given the stubbornness of inflation, the economic damage it’s inflicting on much of the population, and growing political pressures, we now think 75bps may be appropriate at either meeting.

Jerome Powell will also speak on Friday. Markets will be on alert for anything that deviates from what we learn on Wednesday.

Consumer Sentiment is Plunging

The University of Michigan Consumer Sentiment Index fell to a record low of 50.2 versus a prior reading of 58.4 and expectations for a slight uptick. Driving the decline is an increase in one and five-year inflation expectations. Consumers now expect 3.3% inflation over the next five years, up from 3%. Per the report:

Consumer sentiment declined by 14% from May, continuing a downward trend over the last year and reaching its lowest recorded value, comparable to the trough reached in the middle of the 1980 recession. All components of the sentiment index fell this month, with the steepest decline in the year-ahead outlook in business conditions, down 24% from May. Consumers’ assessments of their personal financial situation worsened about 20%. Forty-six percent of consumers attributed their negative views to inflation, up from 38% in May; this share has only been exceeded once since 1981, during the Great Recession.

The report’s featured chart shows the sharp drop in real income expectations, which obviously weighs heavily on the ability to consume.

real income michigan sentiment

Yet Another Recession Warning

We apologize for the recent spate of grim recession forecasts but think its important to stay abreast of economic conditions as this time is different. As a result of high inflation, the investment environment has risks that were not present in prior recessions. Typically, in a slowing economy, like today, the Fed would start spewing more dovish rhetoric. For instance, if inflation were tame, they would likely take 50bps of rate hikes off the table and say future rate hikes are contingent on economic growth. However, the Fed is stuck administering aggressive rate hikes and balance sheet reductions because of high inflation. Less hawkish rhetoric is unlikely until the economy weakens considerably and inflation retreats. Today’s CPI report does not help matters. Simply, the Fed’s ability to “save” the market is compromised.

With the understanding that this time is different, we share another recession warning. The graph below from Pictet Asset Management and the Daily Shot shows that when the real price of oil is 50% or more above its trend, a recession has occurred or was about to happen. Based solely on this graph, we should expect a recession within the next year.

recession warning energy

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Market Sector Buy/Sell Review – 06-13-2022

Each week we produce a chart book of the S&P 500 sectors to review where money is flowing within the market as a whole. This helps refine not only decision making about what to own and when, but what sectors to overweight or underweight to achieve better performance.

HOW TO READ THE CHARTS

There are five primary components to each chart if you want to recreate them yourself in the CHARTING application under the RESEARCH tab.

  • The top chart is the Williams %R set at 14-days
  • The candlestick price chart is bounded by two Bollinger Band studies set at a 50-dma with 2- and 3-standard deviations.
  • Below the price chart is a Stochastic indicator set at 14 %K periods, 3 %K smoothing, and 3 %D periods.
  • The MACD chart at the bottom is the primary buy/sell signal set at 12/26/9 days.
  • Some charts will also compare to the S&P 500 index itself as a measure of over/underperformance.

When the indicators are at the TOP of their respective charts, there is typically more risk and less reward available. In other words, the best time to BUY is when the majority of the indicators are at the BOTTOM of their respective channels.

Major Market Technical 05-01-2022, Major Market Technical Review – 05-01-2022

With this basic tutorial let’s get to the sector analysis.

Basic Materials

  • While inflation is high, it erodes the profit margins of companies that can’t pass those costs along in full. As such we are seeing materials getting impacted.
  • After a brief rally in May that took Materials above their respective moving averages, that failed quickly last week as fears of a recession grow.
  • Materials have broken both the 50- and 200-dma and triggered a short-term sell signal.
  • With Materials sitting on a lot of support at previous bottoms, it is critical that the sector holds it ground.
  • Short-Term Positioning: Bearish
    • Hold current positions with a target to reduce at $85
    • Stop-loss is currently $79
  • Long-Term Positioning: Neutral

Communications

  • The long-term trend line is currently broken
  • After a very minimal bounce, Communications are testing support at previous lows.
  • The previous deep oversold has been mostly reversed and a break of current lows next week will see a continuation of the downtrend in the sector.
  • As noted last update, “the downtrend in Communications from last September will present headwinds to reflexive rallies.” Such continues to be the case.
  • Short-Term Positioning: Bearish
    • Hold current positions with a target to reduce at $60
    • Stop-loss is currently $55
  • Long-Term Positioning: Neutral

Energy

  • In November of 2020, no one wanted to own Energy stocks. Now, everyone is aggressively long the sector. Such is a warning sign in and of itself from a contrarian perspective.
  • Energy is extremely overbought on multiple levels and is pushing more extreme deviations from its 50-dma.
  • Currently, Energy is on a buy signal, but that buy signal is very extended and close to turning suggesting a decent correction back towards $80
  • Short-Term Positioning: Bullish
    • Take profits in current position, nibble on new positions during a pullback from $80-70.
    • Stop-loss is currently $65 which doesn’t make a good risk/reward ratio at the current time.
  • Long-Term Positioning: Bullish

Financials

  • Financials broke below both the 50- and 200-dma with the 50-dma now crossing below the 200-dma. The 50-dma is acting as a formidable resistance to any advance currently.
  • The sector is retesting recent lows at the $32.50 level and is close to 2-standard deviations below the 50-dma. Such previously denoted short-term bottoms and tradeable rallies.
  • The problem this time is that financials are just triggering “sell” signals, rather than being oversold which suggests any bounce will be short-lived.
  • Short-Term Positioning: Bearish
    • Hold current positions with a target to sell at $34-35
    • Stop-loss is currently $32
  • Long-Term Positioning: Neutral

Industrials

  • As with Materials, Industrials are also being impacted by inflation eating into their profit margins.
  • Also like Materials, Industrials are not oversold and is close to triggering a sell signal. While industrials are currently sitting on decent support, a break of those levels will suggest further downside.
  • The 500-dma is not acting as important overhead resistance. The 50-dma is trading below the 200-dma providing downward pressure on the sector.
  • Short-Term Positioning: Bearish
    • Hold current positions with a target to sell at $95
    • Stop-loss is currently $89
  • Long-Term Positioning: Neutral

Technology

  • Technology remains under pressure with the recent rally failing at overhead resistance.
  • Previous minor support from May is holding for now, but with the 50-dma trading below the 200-dma, rallies will likely remain limited to the 50-dma for now.
  • The failed rally over the last couple of weeks is close to triggering a MACD sell signal.
  • Continue to use any rally to reduce risk and rebalance for now.
  • Short-Term Positioning: Bearish
    • Hold current positions with a target of $140
    • Stop-loss is currently $129
  • Long-Term Positioning: Neutral

Staples

  • Staples have come under pressure as rising inflation is starting to weigh on revenue and margin outlooks.
  • Stapes broke, retested, and failed at the 200-dma which had been solid support and good buying opportunities for Staples. That level is now resistance.
  • Currently on an early sell-signal (bottom panel)
  • Short-Term Positioning: Bearish
    • Hold current positions and look to reduce at the 200-dma
    • Stop-loss is currently $70
  • Long-Term Positioning: Neutral

Real Estate

  • Real estate took a fairly sharp hit over the last couple of weeks as rates continued to increase and weakness appeared in the housing market.
  • Unfortunately, the brief rally in Real Estate failed and broke support at the May lows.
  • Currently on an early sell-signal (bottom panel)
  • Currently oversold (top panel)
  • Short-Term Positioning: Bearish
    • Hold with a target of $42-44 to exit positions.
    • Stop-loss is broken
  • Long-Term Positioning: Neutral

Utilities

  • Like the Energy sector, Utilities continue to perform well with the sector holding the 200-dma.
  • Support at the 200-dma has consistently been a good entry point to add holdings and selling when the sector pushes 2-standard deviations above the 50-dma.
  • Currently, Utilities are on an early sell signal. (bottom panel)
  • Short-Term Positioning: Bullish
    • Buy at the 200-dma
    • Stop-loss is currently $68
  • Long-Term Positioning: Bullish

Health Care

  • Health care has performed better this year than other sectors but has certainly seen its share of volatility.
  • Unfortunately, the sector broke the 200-dma, rallied to it, and failed, confirming that resistance level. The 50-dma is set to break below the 200-dma adding further downward pressure.
  • Currently on an early sell-signal (bottom panel)
  • Healthcare is also oversold short-term (top panel)
  • Support continues to hold at multiperiod lows back to October, but that is now the stop level.
  • Short-Term Positioning: Neutral
    • Hold current positions and look to reduce on a rally to $130.
    • Stop-loss is currently $124
  • Long-Term Positioning: Neutral

Discretionary

  • Like Technology, because of its exposure to Amazon (AMZN), the sector continues to perform poorly.
  • The rally over the last couple of weeks fell short of the 50-dma. While not on a sell signal just yet, that will likely happen next week with any further weakness.
  • With the sector not oversold yet, we will likely see a retest of recent lows which must hold.
  • Short-Term Positioning: Bearish
    • Reduce or exit current positions. If you want to hold for bounce, honor current stop levels.
    • Stop-loss is currently $139
  • Long-Term Positioning: Bearish

Transportation

  • So goes the economy, and so goes transportation. As the economy is showing signs of slowing Transportation has come under pressure.
  • Previous support failed, adding to the downward pressure from a declining 50-dma.
  • Currently, the sell signal has triggered and is adding to the downward pressure. (bottom panel)
  • Transportation is approaching oversold on a short-term basis. (top panel)
  • Short-Term Positioning: Bearish
    • Sell current positions on any rally to $75-78
    • Stop-loss is currently broken.
  • Long-Term Positioning: Bearish