Cracks in the Credit Markets
Our short-term signal flipped back green while our mid-term signal remains red (carries more weight in our signaling process). However, it's crucial to note that during periods of market volatility, the short-term signal tends to oscillate more frequently, given its shorter observational duration.
The long-term RiskSIGNAL has remained green, but it has weakened, and we are monitoring it closely. The long-term indicator is structured to be reactive, meaning a more significant downturn might be needed for a signal shift. If we see consecutive lower lows and lower highs in the weeks ahead, there's a possibility of this signal turning red within the month.
In response to the green resurgence in our short-term signal, we shifted our compact momentum strategies. We transitioned from lower beta stocks to a position with greater beta exposure, signifying a higher risk appetite. Nevertheless, due to the persistent red mid-term signal, we've maintained a considerable portion invested in equal weight and lower volatility equity ETFs.
Operational Example:
As a practical illustration, when the indicator signaled increased volatility (red), our portfolio transitioned from market cap weighted ETF (SPY) to Equal-Weight (RSP) and Low volatility (SPLV).
However, with the resurgence of the green signal, we strategically divested from a portion of SPLV, reintroducing SPY into our holdings.
What matters here isn’t being up more, but rather being down less.
Our primary goal is to minimize drawdowns relative to the broader market but maintain equity positioning as such so if the signal provides a false direction or “head fake” our positioning can still capture some of the upside. Moving to a static cash position does not allow us to do that.
Our global macro strategy remains active with core asset allocations to:
US Stocks/Sectors: META, GOOGL, DKNG, SPLV
Emerging & International Markets: India, Japan
Fixed Income: 7-10 Year Treasuries, 20 Year Treasuries, Floating Rate, 3-month T-Bills
Commodities: US Oil, Energy, Uranium, Nuclear Energy, USD,
Shorts/Inverse ETFs (small position sizes): Bitcoin, Small-caps, Large-caps, 7-10 Year Treasuries, 20 Year Treasuries, High Yield, Anti-Beta
If you haven't had substantial investments in what's commonly referred to as the "magnificent 7," encompassing the 5 FANG stocks along with Nvidia and Tesla, your returns for this year have likely been flat or down. To illustrate, the ETF RSP, which tracks the equal-weighted S&P 500, has exhibited a year-to-date decline of approximately -0.84%.
For both active managers and passive investors the past few years have been challenging. The chart below illustrates a comparative analysis of the S&P 500 and the AOM ETF. The AOM ETF can be viewed as a benchmark for a moderate asset allocation strategy.
From the visual representation, it's evident that most investors are down on a cycle to date basis.
The market experienced another week marked by significant volatility in both the Treasury and utilities sectors. This volatility serves as an indication that risk assets may be positioned favorably in the short term. However, it also highlights an elevated downside risk over the long term.
Throughout this week, I anticipate a lot of short-term noise in the market due to ongoing geopolitical developments. Nevertheless, it is crucial not to overlook the ongoing deterioration of macroeconomic conditions and the high vulnerability of the U.S. economy to a potential recession.
The current direction of the market remains heavily influenced by interest rates. Of particular concern are the narrowing Treasury yield spreads, which demand close monitoring. These spreads are approaching a point where they could indicate an impending recession.
I have been very loud for the past year that a credit event is coming and I think we are closer to one today than we were a year ago.
Credit spreads and volatility levels are superior indicators of the prevailing conditions within equity and fixed income markets. Due to their intrinsic interconnectedness, stress in one market is likely a reflection of stress in the other. The current market dynamics vividly illustrate this interplay. THIS IS NOT SOMETHING TO OVERLOOK RIGHT NOW.
One of the most significant factors at play here is the persistence of high yield spreads despite a growing body of evidence indicating fundamental issues in the economy.
Investors seemed determined to underestimate the risks in the bond market, seemingly believing these risks were not real. The truth is, companies with lower credit quality would soon face the challenge of refinancing their debt at considerably higher interest rates. This would likely lead to many of these financially struggling companies going under, or it could even drag down the global economy to the extent that they couldn't meet their debt obligations. In either scenario, it would result in unfavorable outcomes all around.
Credit spreads are now moving to their highest level since July. Now, by itself this is not a sell signal but the move should be monitored closely. When spreads blow out like this, they tend to move very sharp and quick. Based on history, when spreads cross the 6% mark, they generally keep moving higher until it hits 8-10%. This move could happen this month given how yields have been moving lately.
The volatility we're witnessing in one market is having a ripple effect across others, and this is clearly demonstrated by the VIX.
The increased volatility in the bond market has had a knock-on effect, causing a decline in equity prices and pushing the VIX to levels not seen in recent memory.
While a VIX reading of 17 may not be an immediate cause for alarm, it's worth noting that it hasn't closed above 20 since March. For the past four months, investors have enjoyed a relatively stable period with very little volatility. However, it appears that they may be starting to receive a reminder that an accumulation of various risk factors tends to be priced into the market eventually.
No bear market in history has ever bottomed without a VIX spike above 40-45+
Historically, an inverted yield curve that reverts back up has signaled the likelihood of a recession within the next 12 months. The speed at which we are approaching this point is a cause for concern. Additionally, considering that stock prices typically decline well in advance of an officially declared recession, it becomes evident why the prevailing conditions increasingly favor a major sell off.
As you can see below, following the reversion, the sell off in stocks is already in progress or follows shortly thereafter.
How does this story ultimately end? It ends the same way it always does: The Fed will kill it. What I mean is that eventually, the Fed will remove accommodation and it will hike rates to the point where it chokes off economic growth, just like it did in 1999/2000, 2005/2006, and 2018.
Fundamental Drivers of Market Trends
It is essential to maintain focus on the fundamental drivers that underlie market trends. At this juncture, the market's trajectory is primarily influenced by what we may refer to as the "Three Fundamental Supports For Stocks":
Expectations for a gentle economic slowdown
Ongoing trends of disinflation
The Federal Reserve nearing the conclusion of its rate hike cycle
Despite the uptick in yields and the drop in stock values, these three fundamental supports for equities remain intact. Consequently, I continue to regard the market as predominantly range-bound, with a general range between 4,200 and 4,500.
As of September 14, the S&P 500 was situated towards the upper limit of this range, hovering around 4,500. In the past week, it dipped closer to the lower end, approximately at 4,200. During this time, the 10-year Treasury yield has risen by over 45 basis points, and if we seek a primary catalyst for the decline in equities, it can be attributed to this yield surge.
Nevertheless, aside from this increase in yields, there has been limited alteration in the broader economic landscape. Economic growth remains robust from a data perspective, indications of declining inflation persist (we know that isn’t what’s actually happening but that is what the market believes), and the Federal Reserve is either finished with or nearing the conclusion of its rate adjustments (and likely has one more rate hike).
The critical point to consider is that the spike in yields renders a sustained 4,500 level in the S&P 500 unsustainable, as it represents nearly a 20X multiple of next year's earnings, which is not justifiable amidst surging yields.
Conversely, 4,200 is equally unjustifiable, as the fundamentals have not significantly deteriorated over the past few weeks to warrant such a decline. The reality for this market resides somewhere in the middle, and that is where I believe the market "should be" until two key factors become clearer:
The trajectory of economic growth, particularly whether we encounter a growth scare
The path of inflation, whether it continues to recede or levels off.
These two variables will be pivotal in determining the sustainability of the S&P 500 within this range.
If there exists a potential risk of breaking out of this range, I believe it would be to the downside. Itemizing the factors that could negatively impact this market is more straightforward than listing those that could positively influence it.
The potential downsides encompass:
Persistent yield spikes
Economic deceleration
Resurgence in inflation
Further rate hikes
Unforeseen geopolitical developments
An abrupt surge in oil prices
Strain in the banking sector, especially as Treasury yields decline rapidly.
On the other hand, the factors that could yield favorable outcomes include:
A return of Goldilocks economic data
A sustained trend of disinflation
Positive surprises on the geopolitical front
A clear signal from the Federal Reserve indicating the conclusion of its policy adjustments.
Objectively assessing these lists, it becomes apparent that the "Bearish Catalysts" category holds greater plausibility compared to the "Bullish Catalyst" list.
Therefore, if the S&P 500 does approach the upper end of the range and concerns about a decline within the next six to twelve months arise, it would be prudent to utilize this upswing to ensure that your portfolio is suitably positioned for the desired exposure, including a degree of volatility.
However, barring any substantial disruption of the "Three Fundamental Supports For Stocks" the likelihood of a sustained market decline from this point appears to be relatively low (based on fundamentals in the short-term).
Now, is not the time to panic sell to cash or place a lot of weight on shorting the market. In the short-term, conditions are favorable for stocks but I do not foresee that lasting much farther once the S&P 500 reaches 4,500.
And remember - the one fact pertaining to all conditions is that they will change.
Feel free to reach out to me and use me as a sounding board.
Best regards,
-Kurt
Kurt S. Altrichter, CRPS®
Fiduciary Advisor | President