Trick or Treat?
Asking the Right Question
In a week that saw generally positive earnings, rate holds in Japan and the UK, some projected European relief from Italy, October closed as the worst month for equities in over eight years with yields and USD still strong. Globlal markets appear to have stabilized begging the question whether they have finished a major downside retracement in a secular bull market or possibly now just correcting a new major downswing. As a global question that has important important implications for bond markets, the Dollar and Commodities, we believe this is wrongly framed and glosses over what is really happening. To get the right answer (one that is tradeable for the particular instrument you trade), you have to start by asking the right question.
As we start a new month, the wild month of October is still fresh in many traders’ minds and begs many questions. Will November be as bad, has the market topped, has it bottomed—how to approach the volatility? In this week’s newsletter we will try to answer some of these questions, but perhaps more importantly, ask some questions of our own…the right ones.
We have heard the term “markets in turmoil” many times over this bull market. CNBC’s special reports were a actually a good contra indicator that the markets were not in turmoil at all and about to bounce. But this market sell off is markedly different. When market leaders break, we have to sit up and take notice. Perhaps this time they actually are in turmoil.
There can be little doubt FANG stocks have had a rapid and significant change in character. Despite a small recovery into the end of the week, many high flying stocks now look broken. Facebook has spent multiple weeks below its post-IPO trend channel.
Amazon’s (AMZN) monthly bar is clearly a change in pace and direction.
Not only that, the parabolic trend has been broken.
Parabolic trend breaks are very rarely recovered as there is no other trend channel to support the decline. Nvidia (NVDA)—once the poster child of high flying tech—has fallen 40% in just over 4 weeks.
But this panic selling has not been universal. Apple (AAPL)—perhaps the most important stock in the world—has been relatively immune.
Tesla (TSLA), a stock almost symbolic of this bull market and testament of how bullish sentiment and financial engineering can trump fundamentals for longer than fundamental shorts can usually tolerate (or to put another way, how the market can stay irrational longer than you can stay solvent), has held support and shown relative strength.
Meanwhile defensive sectors such as Utilities (XLU), Staples (XLP) and stocks such as Procter and Gamble (PG) actually gained in October; a logical rotation as high beta is being sold.
Driving the action has been a fear of the Fed and excessive tightening, but also a fear of earnings. The market was overly long and complacent into earnings season and the reaction in Netflix (NFLX) set the tone early. Ramping and fading aggressively as it did was a change in character and warned that even decent earnings would be sold into. By the time Amazon (AMZN) and Google (GOOGL) reported, the selling had been done prior to the release.
In such a wild market, correlations can break down and certainly (as we have argued for the last years) in the latter stages of trends. But this tends to happen more in the uptrends than it does in periods of selling. Fear is indiscriminate and we can see how correlations increased recently and at the start of the year.
Panic selling has narrowed previous divergences between the US and the rest of the world, as shown below by VTI (for the US) and VEU (for the rest of the world – in red).
Our software shows a 97% correlation over the last 40 days (during the decline), while previously there was no correlation or even a negative one (during the uptrend in US), a divergence driven by trade wars and problems in emerging markets.
This re-calibration tells us that markets are likely to recover together when the bottom is struck, but correlations will slowly break down as the rally progresses. Not all markets will recover to the same degree or back to new highs and the correlation.
So while everyone is asking, “has the market topped?” perhaps this is the wrong question as it can gloss over so many details and opportunities. If you want the simple answer, we can say here and now that SPX has not topped. Neither has the DJIA, and quite probably neither has NDX. But many markets and stocks elsewhere in the world have. We won’t give an exhaustive list, but some are worth highlighting due to their clarity.
The Indian NIFTY index for example:
So what are the right questions?
We are asking, or rather seeking, markets with clarity, and with the most potential. Whether or not they go to new highs is not an immediate concern as there is a lot of money to be made in the interim.
Markets in the US will be the best buys, and even if broken stocks such as AMZN or FB only manage a standard 61.8% retrace of the previous decline, they can still rally +20%. AMZN gained 13% in three sessions from the low. We could scratch our heads and wonder if it has topped—in fact we are actively trying to figure this out—but we also bought 1530 and seized a clear opportunity while it was there. A stock can be clear in one timeframe and inconclusive in others.
Stocks such as NFLX perhaps show us a possible path higher as its decline was a map we used for other tech stocks in October and its standard 61.8% recovery may also be replicated by related stocks.
Rotation has been a major feature of 2018 and will continue to be. The key to trading the recovery is to pick the right trades at the right times. Sometimes easier said than done but why we look (and sometimes publish) either charts of US index spreads between indices or other European markets. Certainly US sector correlation has been weak. Defensive stocks and sectors such as Utilities (XLU), which arguable topped in 2017 but have made a slow but steady retrace, may be toppy again while riskier markets are trying to find a bottom.
This rotation also has important implications not just for the relationship between different bond markets in the world but also concequently currencies (in theory at least). Also Gold has shown an inverse relation to US equities in 2018 with a beta adjusted correlation of –0.85 over 150 days. There should still be opportunities on the short side as the US recovers.
The key to identifying which markets to trade and when is to identify the key drivers. And pick the clearest markets which are generally the most affected by the drivers. Surrogate or secondary markets tend to be less clear and more erratic as they can be subject to other distorting influences as well. Good luck to anyone who tries the trade USD element of GBPUSD only in the still nervous Brexit market..
We know what has driven the market this week. The question is what will drive it next week and therefore which will be the clearest instruments. With Trump making positive sounds about trade deals and US mid term elections on Tuesday traders will continue to focus on the US. Certainly US indices have shown almost extreme clarity in the last few days and we expect analysis and trading opportunities to be easier because of it. Mid-term elections should therefore provide an opportunity possibly into the end of the year. History and traders have a habit of repeating themselves especially in reaction to political issues. Next week our focus will be just that.. How do you trade from politics?
It is clear what US indices have done generally into and out of midterm US elections since 1930. They ramp. But what do they and USD do in midterms during bull markets and in particular in the latter stages of an uptrend. Similarly how does this link to European political malaise and how do European markets react to political uncertainty surrounding the Italian budget, UK Brexit and German transition.
In the last 3 weeks US earnings season it was the demons who stirred the melting pot. Next week it will be the politicians.
Here’s to making the very best.
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