Submitted By Larry McDonald, as excerpted from his latest must-read Bear Traps report
No one knows where the market is going week to week, all we know is elephants leave footprints. Across asset classes, when large risk hedges are being put forth, there are often clues. These triggers change the probability outlook looking at the near term upside vs. downside, and risk vs. reward equation. As we stressed to clients in February of 2020, there are times to be fully invested (Q4 2018, Q1 2016) and there are times to respect risk. Several years back, we sat down with hedge fund manager David Tepper. Before his now $12B Appaloosa Management moved to Florida, they resided in modest office space in Short Hills, New Jersey. The most memorable part of the meeting wasn't focused on credit spreads or the equity put call ratio, it was the helmets adored by NFL Pittsburgh Steeler fans everywhere. With a glimmering shine, they were placed throughout the entrance and conference room. But there was one pearl of wisdom we will never forget. Tepper said, “ Larry, the market can drive higher with one of two risk variables coming into the picture, NOT three, four and five. I am not saying to go mid evil short, just don’t get caught sitting too frickin ’ long right here . It ´s NOT market timing, just common sense . You are far better off having extra cash for an unexpected, exogenous event .” Over the next 90 days, after taking the stairs higher for months, equities rode the elevator shaft down 15% in the blink of an eye. Tepper, what a legend. A first ballot hall of famer, no doubt. Looking out over the next 90 days, we see a similar seasonal risk setting. Equities may indeed love a delta variant induced, dovish pivot from the Fed but the risk / reward is atrocious here on the long side for the major indexes (S&P 500, NDX). With high conviction, we think gold and silver miners shine over the next 45 days.
On August 17, 2021, there were 350 new lows inside the Nasdaq, the most since March 2020, yes repeat, March 2020.
We have an index making new highs with the internals in horrendous shape. By definition, this alone is a reason to increase cash exposure. The net marginal buyer of equities is in real pain sustained bull markets need this investor. A total of just under $4 TRILLION has been wiped out of just a few hot money ETFs this year.
The totals above add up the cumulative market cap loss of the individual equities within these popular ETFs. There has been nearly $800BN of lost market cap within the ARKK Ark Innovation ETF’s holdings. $90B in Canadian Cannabis names. Over $2T in Chinese tech companies. Over $500B in SPACs. Finally, there has been over $300B of lost market cap in the ICLN Renewable Energy ETF’s holdings.
This speaks to how mega cap equities are the only reason the market continues to trade at the highs. There is significant weakness beneath the surface. The net marginal buyer which drove the bull market is seriously wounded . We suspect mean reversion time is near, cream rose to top otherwise known as the flight to quality.
NYSE Advance Decline and the 50 DMA: Over the last decade, when the advance decline line on the NYSE crosses the 50 day, lookout. With a long term view of the NYSE advance decline line, breaks below the 50 day moving average have led to significant equity market weakness. In July, we got a rare fake out and sharply bounced back to new equity market highs, but a second break of the 50 day just a few weeks later (earlier this week) is a bearish signal ... Real money players are taking.
New 52 Week Highs in NYSE: In May, with the S&P 500 on all time highs, there were 300 to 550 NYSE stocks at new 52 week highs. In June it was 200 to 300. In August it had been 90 to 120. Despite the strong rally on Friday, there was just 32 (!) new fifty two week highs set. This shows an incredible loss of breadth in the equity market. Index strength is being led by fewer and fewer names . A poor risk reward set up.
Volatility Curve Flattening: Capital is piling into near term insurance and downside protection buys. The 2 Month VIX (S&P 500 Volatility) Futures Contract is rising relative to the 8 Month contract (UX2 vs. UX8). After months of gradual steepening (short end falling faster than the longer end), the spread is showing sudden bursts of flattening. It is the speed of flattening that typically means a lot of near term risk is approaching. This week, Amazon’s stock was oversold on the RSI Relative Strength Index for the first time in 24 months, with the last extreme sell off occurring in August 2019. The VIX Curve has flattened a lot, reaching near complete inversion in the front end with Nasdaq and S&P 500 Indices close to their highs, meaning, there is an expectation that there will be more volatility in the next two months than in the next eighth months on average. In recent days inside the VIX front month UX1 was 41% higher UX2 + vs. UX8 + 8% (eight months out) someone is paying UP for expensive near term insurance.
With a longer term view, the 2 vs. 8 month VIX futures spread has moved back into our ‘danger zone’. Historically, the best time to get long volatility is as this spread is rising (flatter curve). It is NOT the flattening, it ´ s the speed of the flattening that is screaming trouble.
Consumer Staples to Discretionary vs. the S&P 500 - Last 22 Years - Heading into all 3 of the prior recessions, the ratio of consumer discretionary to consumer staples (XLP) equities peaked (staples outperformance) well in advance of the S&P 500. After the ratio surged higher following the bottom in Mar 2020, we once again peaked in early Feb 2021 and have yet to take out those highs. Continued outperformance from XLP is a large warning sign for the S&P 500 and the health of the economy overall . Bottom line looking forward your risk reward on the long side is suspect with XLP outperformance.
... and last 4 years - With a closer view, the ratio of discretionary to staples equities has sharply rolled over in recent weeks (staples outperformance). Even in the past few years, sharp pullbacks in the ratio have been a leading indicator for weakness to come in U.S. equity indexes.
Consumer Discretionary vs. Staples Since July 12th: Now in a bear market GM and Ford are 20% off their highs, while the Street promised us to 6% to 8% GDP growth and an economic boom in 2021.
There is a colossal covid driven shift from goods (2020 story) to services (2021 2022 story) that has placed a meaningful fog on retail sales. This has driven consumer staples (XLP) to meaningfully outperform consumer discretionary (XLY) equities over the past month.
BRK.B Berkshire vs. NDX Nasdaq: The ratio of Berkshire Hathaway (value) to the Nasdaq (growth) is catching wind to the upside after bouncing at trend channel support in recent weeks. As inflation broadens out, tech will continue to underperform while the secular shift to value names continues, in our view.
Commodities at the Highs with Aussie Dollar Weak: The Yen (the great risk off currency ) is strengthening against the Aussie Dollar (JPY/AUS on the rise) and is now at 7 months highs. This action in the JPY AUD cross points to near term commodity pain we have moved from high negative correlation to positive, something has to give ... We want to start looking at AUD on the long side.
Forex Vol Surge: The Fed is watching global currency volatility closely. In a covid damaged world, they MUST contain the U.S. Dollar in order to protect the trillions of GDP outside the states. The Canadia n Loonie is off 4% in ten days, the Mexican Peso and South African Rand are the weakest since June and March, respectively. Our rolling model of asset returns (Equities, Rates, Commodities, Credit, FX, and Vol included), point to cross asset correlations picking up again.
U.S. 2s 30s Yield Curve: In early August, the U.S. 2s vs. 30s yield curve spread broke out of the downtrend to the upside and looked poised to make a significant run higher (steeper yield curve). However , with the infrastructure bill in doubt the spread failed to breakout after running into resistance at its 50 day moving average and has since flattened back lower guided by the bid to long end Treasuries.
Nasdaq Composite 20 Day Break: Over the past year the Nasdaq has commonly found support at the 20 day moving average (blue circles), while breaks below have led to significant weakness after (red circles). These led to sell offs of 7.5%, 5.5%, 10%, and 7% respectively AFTER the break (i.e., the distance from 20 day break to next low). After this week ’s break, we reached just 2% below the 20 day before a late week bounce. However, until the Nasdaq rallies back above the 20 day we believe this past data speaks to further downside.
S&P 500 vs. VVIX to VIX Ratio: The implied volatility in VIX (S&P 500 Volatility) options has advanced for five out of seven weeks even though VIX has remained tame. The VVIX/VIX Ratio measures the volatility of the S&P 500 Volatility Index, which also reached a stark level of 7.5. The implication is that sentiment can shift quickly and powerfully. The 7.5 level has been a precursor for numerous drawdown s over the past decade.
High Yield CDX Resistance: The High yield CDX credit default swap index, which measures the cost to protect against credit risk briefly broke above the downward trendline and the 200 day moving average this week. It was the first time the High Yield CDX Index has even touched the 200 day moving average since July of last year. Despite the strengthening in credit on Friday (CDX falling back lower above), we are still at the widest level since March of this year. Energy and CCCs have been the largest contributor to the high yield credit weakness . Credit is under performing.
Russell 2000 Support Break: Small caps fell out of the multi month wedge this week and have since flirted with the 200 day moving average. If small caps cannot get back above prior support, the trend of the least resistance is lower.