As a result of this development, the Stuck in the Middle substack will be on extended sabbatical.  This was not Mr. Blonde’s intention when he started, so he is refunding all subscriptions that were directed at him. Prior month(s) substack fees and all processing fees are unfortunately the cost of doing business. Please be patient as the refund process takes time (some fintech companies are like dealing with your local bank branch, go figure) and there are many to be refunded. Hope to have it wrapped up in a few weeks.

The interest and support over the last year has been incredibly flattering and motivating.  There is clearly intense interest for data-driven, empirically supported balanced risk taking opinion.  

Don’t go too far, this is the end of a scene but not the end of the movie. No need to unsubscribe, there will be no spam but when/if there is a return you will be the first to know.

Good luck trading your view and hope you kill it in 2023.

-Mr. Blonde

• Last week’s CPI report triggered one of the largest US momentum factor shocks on record (> 7 sigma) which continues to reverberate

• Among style factors, momentum is the factor that tends to carry the most ‘macro’ exposure as it latches onto trends and what’s working

• We explore past shocks, seasonality, what makes up momentum and what it might mean for markets

• Risk reduction comes in more than one form. This episode looks more like short covering in the late stages of a bear market rally (at an awkward time of year) but there is scope for regime change given significant macro sensitives in momentum

• Finally, if you have a strong opinion on what this recent volatility might mean please share it in the comments section, Mr. Blonde is staying open minded on this one and a taker of views

Momentum Shock

Momentum investing is a key factor for active equity investors—both quant and fundamentally focused.  Its characteristics are unique because it only uses price performance and therefore its fundamental exposures can (and do) change over time – a chameleon factor.

While many were hyperventilating about the FTX clown show at the circus, active equity market participants were digesting one of the largest two-day shocks in price momentum in over four decades.  Momentum shocks happen for different reasons, but it’s often the case something shifted in the macro narrative to suggest the previous trends are likely to change. Time of year and investor risk tolerance also play a role.   

NB: There are many versions of momentum, but here the measure is sector neutral 9mo returns (9mos – prior month) for the US large cap universe (~1000 companies) with monthly rebalance.

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More Volatile than Usual

First, a long history of sector neutral momentum factor returns shows periods of calm are often followed by clusters of significant volatility.  Perhaps recently lost in the top-down view of equity markets is just how volatile it’s been from a bottom-up perspective even after removing big sector tilts.

Second, the most recent two-day decline in momentum ranks as one of the largest on record (per Mr. Blonde’s daily data back to 1984). Even adjusted for the higher volatility the move represented almost -7 sigma event based on 5yr daily lookback (-11 sigma using full period returns).

Mr. Blonde views momentum as a form of “carry trade” within equity markets. The “carry” comes from persistent incremental good/bad news drives relative performance. That news could be earnings revisions, corporate commentary, a macro factor (i.e. $, rates, commodity, etc.) or more likely a combination.  The primary risk in long momentum factor is periodic narrative shifts that can drive significant volatility.  And volatility is kryptonite for any carry trade.

Such a large shock wreaks havoc on active equity portfolios – think longs down, shorts up – and can be a P/L killer especially for market neutral long/short investors and arguably worse for fundamental investors that pay less attention to factor exposures.

More detail below, but the move was driven primarily by short side of momentum (laggards outperforming) which has been happening more frequently in the last few years as evidenced by the charts below.  Viewed this way it suggests the primary motivation was late year risk reduction following a good 9-10mo trend in relative performance.

Momentum is Macro

The next time someone tells you macro isn’t part of their process and they only focus on company fundamentals, please remember these charts.  While the momentum factor is an extreme representation of this, it has become incredibly difficult to remove macro from the investment process. Implicit risk from this factor is incredibly high.

Currently, the sensitivity of sector neutral momentum factor to macro factors like US Treasuries or US$ is > 2 standard deviations from the norm, which is closer to 0%.  Oil used to be a bigger driver, but the 30% correction this summer resolved a lot of that sensitivity.  Please keep in mind we are using sector neutral momentum here, so this is not about tech/banks, tech/energy or other big sector pairs.

Keep in mind similar exposures are held by CTA/trend following macro investors, discussed here. 

Momentum Fundamentals

Momentum is a chameleon factor and changes to capture whatever is popular at the time — the favorite factor of Hindsight Capital.  Keep in mind the measure used here is sector neutral, so there are an equal number of stocks from each sector on the long and short side (i.e. no big sector bets).  Heading into late last week, momentum was heavily skewed towards low beta, profitable, value stocks. 

You can see pretty clearly from the charts which characteristics are abnormal for sector neutral momentum. What stands out more than anything is the very strong positive correlation to value factors both deep (p/b, p/s) and current (p/e, fcf/ev, etc.) value factors.  It’s incredibly rare for value to have so much momentum and is reminiscent of the extremes during/following 2000 period.

Mean reversion in this sensitivity would make sense. To be clear, mean reversion doesn’t need to mean that the trend goes in the other direction, but even more balance between value and other factors could drive 0% correlation to momentum which would be closer to long term average.

Momentum Seasonality

Its important to point out the tendency for the momentum factor to fail this time of year, particularly during the 1H of November where momentum returns are among the worst of the year over multiple lookback periods.

Mr. Blonde would point out a few potential reasons for this:

1. October is fiscal year end for large % of mutual funds and likely brings meaningful tax loss selling (i.e. sell losers) and therefore potential buying of losers in early Nov,

2. 3Q earnings season is largely complete which means the main fundamental catalyst(s) for bottom-up investors are largely over for the year making shorts harder to defend,

3. significant growth in platform hedge funds with a focus on calendar year p/l (compensation) and unlikely to fight short term market moves late in the year (no time to make up the potential losses) 

This isn’t a PhD thesis paper; Mr. Blonde is just sharing his opinion.  Maybe it’s the lunar cycle (lunar eclipse on 11/8/22), who knows.  Either way the historical stats tell you to be cautious momentum this time of year.

Past Perspective of Momentum Shocks

This table plots the largest 2 day down moves in US sector neutral momentum factor and removes aftershocks that occurred within the month following the first event.  Typically, people believe a large negative momentum move comes near a market bottom, which is sometimes true, but it’s also a feature of bear markets like ’99-’01 and ’07-’09. 

There are two additional important points. 1) increased frequency of momentum shocks in the last few years with very large moves coming from short side of momentum, 2) weak/negative EPS periods an important differentiator when thinking about what follows significant volatility in momentum, 3) subsequent market returns, on average, are inconclusive w/ weak bias.

Often times a momentum shock leads to leadership change. This is admittedly a bit tricky to measure consistently over multiple time periods, but the table below makes an attempt by studying style factor returns in the 6mo period before and after the significant momentum drawdown.  There is some scant evidence of leadership change, but its far from convincing.  

Most interesting is the weak performance of momentum factor in the 6mos leading up to last week (i.e. no momentum in momentum). During past periods when momentum factor performed poorly that weak performance persisted following the shock (’87, ’09, ’20).  Time will tell.

Concluding Remarks

That’s a lot of charts and data to digest. Something Mr. Blonde is still digesting and at this point does not have a strong conclusion on precisely what it means.  It seems to be more a continuation of factor volatility that has been in place for sometime and a feature of bear market environments rather than a sign of a big change in market direction. The fact that it occurred on the day of a positively surprising CPI report highlights the macro importance of the momentum factor and definitely deserves attention. 

If Mr. Blonde had to guess, he’d say it is likely the start of some shift in equity market leadership that leads to more balance between growth/value factors in an environment where rate vol and rate hike expectations become less the focus while growth and recession risk factors increase.

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Disclaimer

• More bounce left in the bear, but margin of safety gone

• Valuation alone a poor reason to buy/sell, but it can define ranges in regimes

• Peak inflation momentum an important first step in healing process

• Crowded positioning will exacerbate moves in a sensitive time of year

• Update on recent ideas

Brief thoughts and observations after a wild couple weeks.  Bottom line, the bear bounce got a second wind from softer inflation print, but chasing S&P 500 at/above 4000 is not likely to be rewarded.  When asked early on, this was a level of interest for Mr. Blonde (here).

Without a doubt, peak inflation momentum is an important and necessary first step to better market conditions, but falling EPS estimates and a Fed still hiking >=50bps increments (+QT) remain stiff headwinds. And we have yet to digest the full effect of financial conditions tightening from the last 6mos.

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Establishing the Range

Current NTM EPS is $229, but is falling at a >2% monthly rate (i.e. negative carry) so assume its ~$225 in a month.  S&P 500 found valuation support around 15.5x forward p/e and peaked in mid-Aug at 18.2x.  Those levels result in S&P 500 price range of 3485-4095 (assuming $225 NTM EPS).

Could it go higher? Sure, markets overshoot, but you would need to be confident in either multiple expansion >18x or 2023 EPS >$225 and/or rising.

Inflation Elation

Clearly markets were desperate for some good news and got it from the Oct inflation report, but the magnitude of response was still a bit surprising.  Didn’t we know inflation momentum was likely to slow?

The m/m fall in core goods inflation for the first time since mid-2020 was important as real time measures of shelter inflation indicate it will come off in 2023.    The direction is clear, the path will be bumpy and the end point unknown.

Real Meaning of Peak Inflation

With inflation momentum peaked and y/y inflation measures coming down, it has put a lid on rate volatility.  Charts below plot US 1y1y rate volatility given market sensitivity to policy action and path, but use any rate volatility metric you prefer (i.e. MOVE Index) and the message is the same.  In fact, US 1y1y rate vol slipped below its 50d and 200d moving averages in the last couple weeks to suggest downside momentum.

As shared a couple weeks ago (here) the peak in rate volatility has helped establish a floor on equity valuation in the 15-16x forward p/e range.  The rate/valuation relationship is also discussed here. Peak inflation momentum lowers the probability the Fed needs to go beyond current rate hike expectations (i.e. peak 5% rate) and reduces a primary source of anxiety. Markets prefer less uncertainty.

However, a floor in valuation is not the same as runaway expansion.  The Fed is still in a tightening campaign and various measures of future growth negatively revised – hardly an environment for sustainably higher p/e multiples.

A Known Unknown

A year end unwind is the big unknown. Nothing against CTAs (commodity trading advisors), but trend following strategies have gotten large — some estimate >$350b before leverage.  Trending markets has resulted in a buildup of positions and lack of diversification across market participant views.  Said differently, everything is the same trade or some version of that ‘trade.’  The common factor appears to be inflation or some form of financial conditions tightening. 

Nothing wrong with crowded trades, they often work…aka momentum.  But given crowdedness such trades are vulnerable to periods of significant volatility. 

Another likely influence is the time of year. Most institutional investors/traders are compensated based on calendar year PnL.  A big slip up in November can be a big headache and wipe out 10 months of hard work, so the willingness to go against the flow isn’t there and can exacerbate short term moves. Recent price action has that flavor, lets see what next week brings.

Charts below measure the rolling 63 day % change correlation of the SG CTA Index (proxy for CTA funds) vs. major cross asset markets: SPX futures, Treasury futures, WTI oil futures and US$ index.  Keep in mind that CTAs don’t care about fundamentals and simply trade the level and momentum of price…pro-cyclical flows.

Trend Still Matters

It would be nice if inflation were are only problem.  Unfortunately, the rise in inflation invited a significant tightening of financial conditions which will weigh on growth over the next 6-12mos, if not longer.  The direction of growth is reasonably clear to most, but doubts remain about severity as many still believe in soft landing or better.

Market based measures of financial conditions indices can be volatile in the short run. Notable is the recent Fed Senior Loan Officer Survey (SLOS) which showed clearly banks have tightened standards and in many areas demand for credit has pulled back. The great twitter: @IanRHarnett highlighted this with a chart of net % of banks tightening standards leading by 9mos vs. US speculative grade credit default rate. 

Bottom line, the tightening of financial conditions has yet to show up in the real economy in a material way ex housing. Many assume its because the economy is more resilient, but Mr. Blonde thinks the weight of evidence is clear and they just haven’t given it enough time (here).

Are you gonna bark all day little doggie or are you gonna bite?

Brief update of recent ideas and will offer some new ones this week.  

Utility Futility

Back on 9/30, Mr. Blonde recommended buying oversold Utilities as a measured play for a bear bounce. In hindsight this was not a great call as Utilities sold off into mid-Oct.  The view was based on short term mean reversion and a data study spanning more than 30yrs.  This just serves as a reminder that even good setups have a probability of being wrong.  This trade has room to recover further, but it is substantially smaller for Mr. Blonde as we pass the window for mean reversion to work.  Want to stay disciplined in a difficult market and not trying to stretch a single into a double (baseball analogy).

Software / Semis

This ratio has been pretty frustrating this year as its shown signs of working only to be smacked down into a sideways, choppy range.  The last couple months has proven to be more of the same just as Mr. Blonde thought it was setting to break its downtrend. 

Unfortunately, the negative fundamental reports from semis in Sept-Oct period were followed by negative fundamental reports from software as the groups trade punches.  So the short term technical picture has weakened, but overall picture has not changed much with sideways choppy action and some upturn in moving averages. 

Falling PMI environments typically favor groups with less cyclical earnings streams and that has been the case today as well between software and semis. The big headwind for software stocks was expensive valuation and over ownership coming into 2022, but both seem to be in a better position today.   Frustrating to date, but still think this can be a good pair into 2023.

Oh Mo!

A couple weeks ago Mr. Blonde suggested long MTUM (momentum ETF) vs. SPY.  This commentary is already too long, so there will be a separate post on the recent evens in the momentum factor and what it might mean for markets.  Sticking with this one for longer as the quality + value composition of momentum remains attractive as does the sector composition energy + health care + staples for the macro regime (i.e. late cycle weak growth, peaking inflation).

Coming soon…a post on the earthquake in the momentum factor last week and what it might mean for markets as well as a data driven wrap up of 3Q earnings season.

good luck trading your view

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Consistent with call for a Bear Bounce a month ago, equity markets are up in three of the last four weeks and +8% in Oct. Some had the guts to participate, many fought it, naturally the question is what to do now?

The knee jerk reaction is to sell into the FOMC meeting this week where they are unlikely to placate “pivot” dreams.  Mr. Blonde expects FOMC message will stay consistent and suggest rate hikes will continue until realized inflation falls to a manageable pace and level. Don’t expect any pre-commitment on magnitude of rate hikes and continue to keep options open. All told though, that message from the Fed is not really new…its more of the same.

Following the last few weeks, Mr. Blonde finds himself with a more neutral tactical view and expects price action will exhibit more two-way risk from here. Its sensible to reduce tactical long exposure put in place a month ago, but not yet ready to go hard in the other direction. 2022 has been a year to sell rallies and buy dips…while expecting bigger dips.

A few charts and thoughts supporting that viewpoint:

FOMC First

There are plenty of people to pontificate on the Fed…for some it’s sadly a full-time job. Inflation momentum peaked and inflation is likely to stay an important debate in 2023, but its too early for the Fed to declare victory and they are likely to choose to do too much rather than not enough — the cost associated with a “late and fast” policy strategy.

Mr. Blonde is sure the Fed is happy about the early signs of slowing inflation momentum, but they are unlikely to ease off the brake until they are confident inflation is coming down toward target.  Perhaps a discussion for 1Q23.

Nothing Wrong with Neutral

Expect S&P 500 price stalls around 17.5x forward P/E, which currently equates to ~4075 (or +4%) based on consensus EPS of $233 (and falling) for 2023.  Why 17.5x?  Historically, valuation multiples compress as long as the Fed is hiking rates (yes even if hiking at slower pace) and rolling 1yr average acts as an area of resistance.

Bottom line, Mr. Blonde feels tactically neutral at current levels with a core view that remains defensive.  Shorting the FOMC meeting feels a bit too obvious, but chasing a +10% moves has not been rewarded this year. Sometimes it’s best to sit back, observe and wait for direction.

Technicals & Tactics

The short-term technical backdrop has improved quite a bit recently and another 4% is not out of the question.  Such a move would put SPX ~6% above its 50d average and likely leave +80% of stocks above their 50d average—both on par with mid-Aug highs.  Given the deterioration in fundamentals since then such an outcome strikes Mr. Blonde as a bit much without a genuine shift in Fed thinking, which also seems unlikely.

Systematic Support

A primary driver of the early August move higher in stock prices were systematic strategies which turned buyers (short covering) in an environment to low/no trading liquidity.  This remains a positive risk factor today and if we get that +4% move in S&P 500 its likely this group is a key contributor—a wild card.

Mr. Blonde has yet to find a clear and definitive measure of CTA exposure or timing signal, but most across the street agree the group is near max short, covering and is a buyer higher.  This could be a swing factor later this week and something to keep in mind.

Its Earnings Stupid!

Technical rallies driven by positioning and sentiment are a feature of bear markets (here).  They are confusing, frustrating and often defy logic. They are typically violent and can inflict significant damage to unprepared portfolios.   But they are also short lived, counter-trend affairs and then the market reverts to trend.  While this bear market rally may have a bit more life, the trend remains negative as EPS trends are now clearly negative and represent a stiff headwind.

Mr. Blonde previously shared his view of rolling changes in NTM EPS and its influence on market returns. This table serves as a reminder that periods of falling NTM EPS are typically a bad backdrop for equities with average 3mo returns of -3.7% and positive returns less than 40% of the time, both significantly below average. Selling rallies is a favorable strategy.

Paid to Wait

Moving to a neutral position is far less punitive than it used to be.  US 6mo Tbills now offer 4.5% yield which is quite competitive vs. the equity earnings yield or even US BBB corporate cash credit yield of 6.5%.  This is a meaningful adjustment within capital markets and one that is likely to be felt over the course of several quarters as multi-asset managers gradually, but consistently, shift towards no volatility, modest return offered by cash.

Regime Relative Performance

In early March (here), Mr. Blonde provided a framework for which parts of the market to focus on in an environment of falling ISM and rising y/y core CPI.  Such analysis serves as a useful guide on where to spend time on both the long and short side. Its not a black box model, but a regime roadmap to guide judgement.

In March the focus was on how to trade for “stagflation” regimes as rising inflation in the face of falling growth momentum is a unique circumstance for most of the last 30yrs. Growth momentum (i.e. ISM) is still falling and y/y core inflation is still rising, but 6mos from now its probable y/y inflation momentum will be coming down alongside growth.

The table outlines different regimes of ISM and y/y core CPI momentum with coincidental relative performance of various US industry groups.  Historically, “stagflation” suggests the worst environment for broad markets with lowest return and probability of positive performance (% +ve). This eases somewhat when y/y inflation also starts to fall as it likely gives scope (hope) for central bank support to enter the discussion. 

“Contraction” environments favor outperformance of pharma & biotech, real estate, utilities, consumer services, food/beverage/tobacco, media and telcom services…many which overlap with “stagflation.” Underperformance in materials, autos, banks, consumer durables and transportation should continue.

Bottom line, the historical and expected regime continue to favor defensive group allocation within equity markets.  And since the majority care…energy is still positive, but exhibits more relative performance volatility than other groups.

Stock pickers should study sector neutral style factor returns across the same macro regimes. Unfortunately, detailed style factor returns are not widely available beyond the mid-1980s so we miss some extreme high inflation periods, but still capture rate of change, multiple environments, and the results are rational.

The current and expected environment favors a mix of profitability, price momentum, low risk and current value (i.e. FCF/EV).

Please see below for more detailed explanation of sector neutral style factors.

Are you gonna bark all day little doggie or are you gonna bite?

A couple trades and ideas on Mr. Blonde’s mind along with a relevant idea screen for the stock pickers out there.

Sell Rip, Buy Dip Structure

Mr. Blonde has his eye on SPY put spread collar to dial back risk and take advantage of the recent bear market rally. This structure is not for everyone and can deliver painful mark-to-market PnL in the short run, but it fits Mr. Blonde’s view on time and price. Sell SPY 12/16 410c to buy 375/355 put spread for close to zero cost.

Note the payoff profile and risk associated with short term up moves. Do your own due diligence.

MOJO Rising

Long side of momentum currently has the right characteristics and sector exposure for the environment. Technically the relative price chart has broken above its down channel and momentum has momentum.

MTUM etf is currently overweight energy, pharma & biotech, food/beverage/tobacco, and health care equipment & services. It is underweight software, media, retail, banks, tech hardware and semis.

The style factor attributes of MTUM are more interesting with outsized exposure to profitability, price momentum (duh), low risk and FCF/EV so current valuation is close to neutral.

Taking it to the Stock Level (h/t: HM)

The below screens leverage the regime work above to filter the US large cap universe across groups historically favored during periods when ISM Manufacturing and y/y core CPI are falling. 

The style factors here are sector neutral and represent the cross-sectional z-score for each metric where higher reading represents of the fundamental exposure.  For example, +1.0 profitability reading means the company’s profitability is +1.0 standard deviations above the sector average.

The screen here is purposefully large and threshold criteria loose so stock pickers can go to work.  Not every stock on the screen will outperform, but on average you would expect they perform better than the market and better than their respective sector.

The list is sorted by industry group and then descending by its profitability score.

This screen uses the same criteria as above, but is not filtered for the groups that typically work during periods of falling ISM Manufacturing and y/y core CPI. These are the remaining companies that met the style factor criteria irrespective of their sector classification.

Sorry for the long post, the regime work should probably be its own post but thought important to provide context on internal opportunities as well. Will follow up on this work in later post with more detail by period and executable ideas.

Good luck trading your view.

Sector Neutral Style Factors

Sector neutral factor exposures reflect cross-sectional z-score exposure for various fundamental factors. For example, +/- 1.0 Profitability reading suggests companies profitability is 1.0 standard deviations above/below sector average.

Style factors are rebalanced monthly from a US large cap universe (~1200 companies).

composite style factors and sample of inputs:

Deep Value = price/book, price/sales, cash/market cap

Current Value = forward p/e, trailing p/e, FCF/EV, EBITDA/EV

Profitability = gross margin, ROE, ROIC, ROA

Growth / Momentum = 9m price momentum, earnings revisions, long term growth estimate

Risk = beta, size, debt/equity, ROE volatility

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Brief post updating earnings season statistics and make some chart driven observations to put the season in perspective to this point.

Before touching on reported fundamentals, the main story of earnings season so far has been stock market performance. As a result, many will suggest “earnings are good” but first consider the earnings season setup score (ESSS) which Mr. Blonde flagged a couple weeks ago (here).  Bottom line, US equities have a tendency to perform well during earnings season and that performance tends to be stronger when pessimism is high coming in as it was today. But stock price performance alone shouldn’t be used to determine the quality of earnings season.

In aggregate, earnings “beats” continue but at a substantially slower pace that past seasons and when we consider the breadth and magnitude of negative revisions to 3Q forecasts it can hardly be considered a “beat.”

To date, 266 of S&P 500 companies, representing 71% of market cap, have reported. As typical, more than 60% “beat” EPS, but surprise magnitude at +0.9% is well below average and more groups are showing negative y/y EPS growth trends.

Sales trends have been better both in terms of surprises and y/y growth rates as the elevated nominal growth environment has been supportive. This has the potential to change in a meaningful way in 2023 as nominal growth falls off in response to tightening financial conditions.

Similar to 2Q earnings season we see negative revisions to 4Q estimates as companies report.  Negative revisions to the subsequent quarter is not all that uncommon, but the magnitude is running more than normal and it’s a clear change when comparing to the recent past.

The energy sector has been a source of relative strength, but even there its proven hard to hold things up as oil prices slipped below $100.  The breadth of negative revision trends for both 3Q and 4Q shows clearly how growth conditions have changed in 2H22 and heading into 2023.

This table provides detail by group and is sorted by 4Q23 EPS revision over the last month.  Virtually no where to hide with confidence.

The negative revisions are carrying over into the 2023 profit outlook and likely to continue to do so.  With NTM (next twelve month) EPS now falling, equities have negative carry attributes and represents a stiff headwind to returns.  

A detailed look at US earnings growth and growth contribution sheds light on where market is expecting growth to come from next year.  More to discuss on this later, but negative contribution from energy and pharma look too pessimistic in 2023, while retailing, capital goods, consumer services, autos, transportation, and tech hardware look optimistic.

Earnings continue to track along the forecast Mr. Blonde has had from the start of the year…growth deceleration this year turning into negative growth later this year into early 2023 (here). So far, nothing from recent earnings seasons would suggest that its off track, if anything, its a bit ahead of schedule.

Hope you appreciate the earnings season perspective and observations. An updated view following the Bear Bounce call from a month ago will be shared soon. Stay tuned.

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Brief market thoughts and very early earnings season observations. Bottom line, we’re in a tug of war between crowded thinking and still deteriorating macro conditions. This choppy, violently sideways price action can linger longer until we get new bad news to push us lower or enough time passes for fundamentals to deteriorate.  The violence of upside moves suggests there’s value in holding shorted dated calls or call spreads, but as time passes the confidence for a meaningful bear bounce passes with it.

Violently Sideways

On 9/30, Mr. Blonde suggested the pre-conditions were in place for a bear market bounce (here, here). As suggested at the time, trading against one’s core view is mentally difficult and not for everyone.  While markets shot higher initially, they have been violently sideways since.  5-6% rallies with 3-6% sell offs reflects a market that lacks conviction and doesn’t have new news to move it meaningfully in one direction or the other.  

Mr. Blonde would give his Bear Bounce call a C+. The strong move in first few days of October suggests he was on to something, but the lack of follow through since has failed to impress.  That said, it has not been a good strategy to press shorts either.  The last few weeks have something for everyone but satisfied no one.

The Upside Down

One of the more interesting developments recently and felt in price action is the magnitude of up vs. down days.  The average up day is exceeding the average down day over the last month and indicates a market with more urgency on the way up.  This is reflects positioning and sentiment as well as trading dynamics (i.e. see options market).

All told, this escalator down, elevator up environment supports Mr. Blonde’s opinion to maintain a defensive, risk off, portfolio but tactically consider short term calls or call spreads to mitigate volatility from short, sharp upswings.  More aggressive, active traders would consider the ranges and more aggressive dip buys…just don’t forget to sell.

Gravity is a Force

Working against bearish sentiment and positioning is a strong gravitational force. This issue is something Mr. Blonde has been highlighting for 10+ months and is the result of the Fed hiking into a cyclical growth slowdown (here). Periods when cost of capital is rising and EPS is falling are incredibly difficult and significantly increase the speed of financial conditions tightening.

First, consider the speed and magnitude of change in cost of capital is significant.  The change is significant because it was the primary driver of asset price valuations for the last decade.  Many times over the last 3yrs the equity market was called a “bubble”, but equity valuation (earnings yield) was just following cost of capital lower in the era of financial repression. Rising EPS and falling cost of capital is a powerful tailwind that is now a headwind.

Maybe we will enter some new valuation equilibrium and equities can live with higher yields? That is certainly a possibility as the above charts highlight, but a transition to that new backdrop has been and will be a painful process.  With US BBB yields at 6.5% (yes you read that right) and consensus EPS for 2023 at $237 (and falling) the implied price for S&P 500 is ~20% lower and represents a strong gravitational pull on markets.

Bottom line, for there to be a durable up move in stocks we will need rate volatility to subside and need EPS revisions to turn positive.  While the window for a bear bounce remains open, it would be wrong to lose sight of the trend.

Early Earnings Season

The bulk of earnings season (~65% of S&P 500 market cap) will report after 10/24, but through Thursday evening 101 S&P 500 companies reported, or guided, with 65% exceeding lowered forecasts and delivering a median surprise of 1-2% on sales and EPS—well below what’s been delivered in recent quarters. S&P 500 is tracking y/y quarterly net income growth of +0.1% and -6.5% ex energy on sales growth of +9% and +6.6%, respectively.

Of course 3Q reports will be an input for markets, particularly big surprises, but more important will be quality of report (i.e. pricing, margins, etc.), management update and characterization the environment into 2023.  Mr. Blonde will use 2023 estimate revisions as a gauge for the health of the quarter as revisions typically encompass the current quarter, quality of the quarter and guidance.  Notice how 2023 revisions trended during and after 2Q earnings season…a pretty good tell.

In addition to aggregate revisions, its useful to look beneath the surface.  Only energy has positive EPS revisions and barely. Cuts are likely to continue, just a question of severity.

Price Doesn’t Lie

The other effective way to evaluate quality of earnings season is to cast a wide net (i.e. S&P 1500), adjust earnings surprises for dispersion of estimates, evaluate relative performance in the days around report date, study significant surprises and evaluate historically for context.  Sounds like a lot…it is, but far more thoughtful than “70% companies beat” without any important qualifications.

While only 200 companies reported from this larger universe, the early results make clear misses are not tolerated.  The market correctly recognizes the importance of robust, high-quality profits at this stage in the cycle.

Following the Forecast

Mr. Blonde’s view on the earnings cycle is unchanged from very early this year (here). Growth deceleration and negative revisions this year that turn into negative growth rates in early 2023.  Nothing from recent reporting seasons suggest that view is not on track.  Before its all over, S&P 500 EPS will be closer to $200 or less from its current $220 and compared to 2023 expectations of $237 (down from $252 earlier this year).

Just a quick note to share some observations and thoughts in what has been a violently sideways couple of weeks. Pretty low sharp ratio environment in equities at the moment as we await new news. Maybe we’ll have some clarity before end of earnings season and the next FOMC meeting on 11/2. Good luck trading your view.

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In Bear Bounce? Mr. Blonde suggested the pre-conditions for a countertrend risk rally were in place.  Shortly after, when everyone realized CSFB wasn’t Lehman 2.0, we posted one of the best two day gains in the last decade.  Then faded and fell hard on what seemed to be a largely inline NFP report and the negativity returned in force.  The bear bounce view has hardly been a no brainer, but seems to still have life.

Bear market rallies are typically vicious and don’t always jive with rational, fundamental explanation. They are primarily technical, positioning events.  All of the ‘pre-conditions’ in the 9/30 commentary are still in place.  Again, the fundamental core view remains the same (SPX to 3000-3200) and trading against one’s core view is uncomfortable, but we try our best to be unemotional and data-driven.

A few brief observations and then some ideas to consider.

Technically Speaking

Visually, S&P 500 retraced 50% of the move from covid low and bounced hard to regain the also closely followed 200 week moving average. There was also a very large outside day reversal today and we closed strong on above average volume. The price can change tomorrow, but in the context of a disappointing CPI report markets held/regained important technical levels.

History Rhymes

In addition to the pre-conditions, the trading behavior today with the last time we started a bear rally has uncanny similarities both in timing and pattern.   Since Sept quarter end, markets went up quickly only to fall into today’s CPI report…similar behavior in July. Both CPI reports experienced a sharp selloff, only to rally back hard on the same day.  SPX futures retested and briefly undercut the June quarter end low and is showing similar pattern today.  This a single sample and hardly rigorous analysis, but a reminder we’ve seen this behavior before…not long ago actually.

Mr. Blonde maintains Oct month end SPY call spread referenced in the Bear Bounce note and has added some Nov calls for some added leverage. If we get to next week without anymore UK pension drama the narrative can change. And don’t forget about the potential for pro-cyclical CTA flows.

Earnings Season Setup

2Q earnings season was confusing. Pundits said earnings season was “good” and that’s why stocks went up, but when you actually study the facts to see numbers were cut meaningfully into the quarter and revisions coming out of the quarter were negative its hard to say it was good. 

A better description may have been that 2Q results turned out better than feared.  But how do we measure that fear? Mr. Blonde created the Earnings Seasons Setup Score (ESSS) to try to quantify this fear.  The ESSS is an aggregate of revisions, survey sentiment, and measure of overbought/sold conditions.

Evaluating this measure at the start of each quarter from 1Q00 and comparing to market returns during the first few weeks of earnings season highlights how “better than feared” results can drive performance.  Last quarter had a reading of -1.6 at the start of earnings season and entering tomorrow we are -1.8.

This analysis says nothing of Mr. Blonde’s fundamental outlook on earnings. This is about market expectations vs. what is delivered at this point in time. The ESSS and chart below simply suggest markets may already be braced for bad news.

Mr. Blonde will have more to say on 3Q earnings season in the coming week.  The results won’t be great and corporate guidance is likely to be downbeat, but market conditions suggest we already know that.  The earnings debate is no longer about direction, but severity and timing of that severity. Will it be 3Q? could be, but it could also slip into 4Q. 

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Are you gonna bark all day little doggie or are you gonna bite?

There is more than enough ‘bark’ each week with pundits pontificating about markets, their feelings and what markets should be. Mr. Blonde tries to dedicate time in each post to where there is ‘bite’ and interesting, relevant trades that can be added to a portfolio given current and expected market conditions. 

Not every trade will be relevant to everybody, that’s just the reality of markets and the wide range of risk tolerances or time horizons. This is not a paper portfolio and not an outsourced portfolio of ideas to set and forget. As always, doing your own due diligence is highly recommended.

Short Eurostoxx 2023 Dividend Future

please note: 2023 dividend futures are paid out of 2022 profits — something Mr. Blonde misunderstood at the time of this idea. He incorrectly assumed the convention was similar to US dividend futures which payout when realized. This would make 2023 future less attractive short and favor 2024 future short, but 2024 is implying -10% growth and therefore a less compelling risk/reward. sorry for confusion.

A year ago, Mr. Blonde recommended S&P 500 dividend futures as an important alternative to long S&P 500 exposure with the opinion that a Fed rate hike cycle would likely significantly compress valuation multiples even as realized growth held up well.  In a difficult year for most assets, this proved to be the right call:

Heading into 2023, the backdrop changed as fundamental growth risks are high and rising.  Some weakness in profit growth was likely given overearning post COVID stimulus, but we now layered on significant financial conditions tightening and geopolitically driven energy price spikes that will further weigh on growth (here).  Mr. Blonde likes to trade this risk by being short DEDZ3 futures (Eurostoxx 2023 dividend futures).

Currently 2023 dividend futures imply growth declines 5-6% in 2023, but could ultimately prove to be 3-4x. In europe, dividend growth and earnings growth are closely tied.

Europe earnings growth tends to be high beta relative to US given its exposure to global trade and more cyclical composition.  Using the Macro Growth Composite as a guide suggests y/y Europe earnings growth down 20% or more.  This is consistent with the relationship of y/y M1 and Europe PMIs as presented by the must follow @IanRHarnett and @asr_london of Absolute Strategy Research.

Eurostoxx is likely to perform poorly in such a scenario, but with the index already trading at 10x forward p/e it may not offer the desired asymmetry and history suggests equity prices bottom 6-9mos before EPS bottoms. 

Bottom line, short DEDZ3 (ticker: DESX5 on interactive brokers) as the next phase of the market correction is primary about earnings disappointment.

Long Low Risk

A repeat idea that still has merit. In fact, the investment case has strengthened with another wave of financial conditions tightening and ISM falling to 50.9.  As fundamental conditions weaken following the sharp tightening of financial conditions we will see companies with high volatility, cyclical cash flows come under great pressure. This pair trade is long the lowest beta and short the highest beta stocks within each sector across the market. 

Mr. Blonde continues to see this as a way to be long volatility without paying the negative carry associated with long volatility (i.e. VIX futures).  For institutional investors most dealers offer a relevant equity swap pair to reflect this view, while retail traders can position via BTAL ETF (AGFIQ US Market Neutral Anti-Beta Fund).

Utility Value

This idea was shared last in Bear Bounce? .  Needless to say, the underperformance last week was incredibly frustrating. It’s of course possible we end up in the 20% of cases when some mean reversion doesn't work, but empirical odds suggest XLU higher in a month (historically its higher 80-88% of the time from such oversold conditions).  So, Mr. Blonde hates the outcome so far, but he doesn’t regret the buy decision.

Not certain, but suspect some of the recent selling pressure may be related to retail boomer selling and/or a low volatility equity unwind (see weakness in REITs, WM, RSG, JNJ, KO, SPLV, etc.) perhaps UK pension funds?

This signal first hit last Friday with a reading of -3.1 and -4.7 yesterday.  Giving this one a bit more time to work.

Software over Semis…Still

The tech sector is incredibly controversial given its long period of outperformance and ownership.  Long software / short semis is a pair first suggested in late Jan’22.  The view at the time was to capitalize on oversold conditions in a pair trade that historically performs well during periods of negative cyclical growth momentum (falling ISM).  Within the tech sector this is a play on defensive/cyclical as semis are far more exposed to goods sector, inventory gluts and global trade disruptions. Software’s main issue is it was expensive and over-owned, but after the sharp sell off at the turn of the year this risk seems to be in a better place…at least relative to other tech groups.

It’s too early to be confident, but Mr. Blonde thinks this has the potential to be an important pair in 2023 if the recession forecasts come to fruition and growth takes over from inflation as the driver of rates.

Bottom line, long software (IGV) and short semis (SMH) has an improving technical picture, the right characteristics for slowing growth environment and in a scenario where yields stalled out or fell could remove a macro pressure point.

That’s all for now. If you appreciate these insights please like, comment and/or share. Planning a 3Q earnings season preview sometime in the next week and will comment on the bear bounce view if conditions change.

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Mr. Blonde hoped to take a break from broad market commentary to share a few trade ideas, but recent volatility deserves a comment.  The Bear Bounce view was well timed, but the price action late last week raises serious doubt worth evaluating.  Bottom line, while it doesn’t feel great there’s still a chance.

Bounce or Breakdown

Last week is characteristic of bear market trading environments. Bulls frustrated, bears frustrated and only the nimblest of traders had much of a chance to feel satisfied.   Big stumble late in the week hardly builds confidence, but S&P 500 actually finished with the first weekly gain in four and keeps the bear bounce a possibility. 

A few brief broad market observations:

First, a similar pattern took place off the June low where a sharp move up to falling 20d average was initially retraced.  Also notable was the behavior around June quarter end which included a sell off on the last day of the quarter, rally in first few days of July, and then a retest of the quarter end low.  Its far from perfect, but the similar behavior also suggests its too soon to count out the bear bounce possibility.

Second, the sell off in equities seemed large relative to ‘new’ information provided by the jobs report.  In Mr. Blonde’s opinion the report did little to change the path or magnitude of Fed rate hike expectations.  For example, no real movement in US 3m10y swaptional vol (yellow) to suggest equities should have repriced by so much. Of course, markets are imperfect over short time frames, so we could learn something different his week, but the equity move seemed large vs. the message from non-equity assets.

Third, credit markets didn’t have nearly as large a reaction.  HY CDX for example only retraced 38.2% of its rally while SPX retraced 76.4%.

Fourth, estimates suggest CTA equity selling is largely complete and the risk has shifted toward slight buying in a flat tape.  This was also a feature—a big one—of the Jul-Aug bear market rally so deserves some attention. 

Mr. Blonde won’t pretend to be an expert in this area (there aren’t many), but he does recognize its become an increasingly important flow given non-existent trading liquidity. 

Over the next month, GS estimates $38b to buy in a flat tape and $140b to buy in a modestly up tape.  Naturally the pro-cyclical nature of such flows can be somewhat self-fulfilling without active selling pressure on the other side. The key takeaway here is previously big seller is now short and more likely to be a big incremental buyer than seller from here.

Fifth, earnings season historically is not the best time to be broadly short equities…even during periods of weak quarters.  Also notable is the tendency for negative returns into earnings season to result in positive returns during the season. Directional earnings weakness is no longer much of a debate and the question is one of severity and timing of severity.

Bottom line, Mr. Blonde is holding his month end Oct call spread recommended here and still leans in the direction of a bear market bounce. Without a doubt, Friday’s price action raises an eyebrow but as highlighted above there’s still a chance.

A subsequent note that focuses on relevant and interesting trade ideas for the current environment will follow shortly. Good luck trading your view.

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The Stuck in the Middle commentary will require a paid subscription come 10/31/22. 

Anyone subscribing by 10/31 will pay $30/month without increase through at least 2024.  The price point is low, less than most spend on coffee in a month, and shouldn’t be a difficult decision for most. Monthly subscription is the only option, so no strings attached and no commitments. A simple pricing model for both of us.

After sharing institutional grade commentary, framework, cross-market analysis and insightful empirical analysis for the last year Mr. Blonde hopes the value proposition is crystal clear and will not be a difficult decision for you.  You can study the last year’s worth of posts, but in addition to quality work you will find timely responses to posted questions as well as openness to discuss views and share accumulated knowledge.

Why paywall?  First, Mr. Blonde believes in capitalism and values his time. Sharing market opinion is something he enjoys but its not free and money motivates. Second, subscription revenue will compensate for data, software tools, research expense and allow for investment in analytics and support.

There will be occasional free posts and its likely older posts will be unlocked for periods of time in order for others to re-consider not paying, but will never overshare or dilute your paid subscription.

Hope you agree and will sign up,

Mr. Blonde

More here about Mr. Blonde’s experience and approach:

https://stuckinthemiddle.substack.com/about

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Sharing these observations is incredibly uncomfortable as markets are on edge and in a weak and weakening environment accidents can happen as observed in UK this week.

But the pre-conditions are in place for a bounce, we just need market narrative to shift to something positive. Could it be the fall in breakevens? Putin’s olive branch? BOE’s recognition of financial stability risks? Another “better than feared” earnings season”? Mr. Blonde doesn’t know, but they are all possibilities and when sentiment is depressed with oversold conditions it typically doesn’t take much.

None of the below changes Mr. Blonde’s core fundamental view and the likely trend in markets. This is a note for traders and tacticians, if not your thing or you don’t want to hear it then no need to read further.

A few charts and market observations that have his attention:

Oversold

First, markets are short term oversold and 100 different charts could be displayed to highlight this. Only 9% of Russell 3000 stocks trade above their 50d moving average — that is low. S&P 500 is trading 10% below its 50d moving average which is more than -2 sigma based on daily data from 1980. Could it go lower, yes its possible, but risk/reward doesn’t favor pressing shorts from this level.

Are you Afraid?

So far this year, 5d average VIX above 30 has been enough to represent a near term low. Maybe it won’t this time, but add this to the other measures of sentiment and positioning that have met criteria for a near term bottom.

Pain from Positioning?

Second, fast money positioning has compressed significantly. They are still net long and Mr. Blonde isn’t convinced the last decade of net exposure is a great benchmark given macro conditions, but the lowest beta adjusted net exposure in over a decade isn’t nothing. Similarly low/short exposure is seen in CFTC futures positioning.

Equity long/short funds have had a horrific performance year on average. It would be a real gut punch to have a late year countertrend bounce in risk markets as everyone ran for cover. Murphy’s law in action.

Sentiment Stinks

Sentiment stinks, rightfully so. But when sentiment is this compressed it doesn’t take much good news to positively surprise markets. Mr. Blonde isn’t certain what precisely will deliver that news he just recognizes the market isn’t really expecting it.

Better Seasonals?

Seasonality into September is bad and was previously noted here. Despite many dismissing it, it works on average. Of course seasonality is not the only consideration, but if you come into a historically good seasonal period with oversold conditions and compressed sentiment it deserves some consideration. Mr. Blonde’s suspicion is alot of tax loss harvesting may have been conducted in Sept…just a guess.

Either way, historical probabilities suggest October is a good month even during bad market years (i.e. SPX < -10% YTD thru Sept). You can dismiss this factor, just know its a possibility and something that’s moving from the liability to asset column.

Bear Rallies

Not much to say here other than we appear to have met the minimum criteria for a post bear rally sell off. Mr. Blonde would feel better if SPX was further below the June lows, but enough other signals are evident that its worth mentioning.

Glass half full?

Are we finally getting relief from a key macro risk? US 10yr breakeven inflation is making a new 52wk low. Of course this is related to weakening demand and falling commodity prices (see CRB RIND Index), but its also a necessary pre-condition for central banks to back off. Speaking of backing off, Bank of England stepping into address a financial stability risk is good news. Maybe interesting that Brainard made reference to monitoring financial stability risk today too. Unlike previous policy leaders who said they see none and not to worry.

Bottom line, the pre-conditions are in place for a countertrend bounce in risk. This is an uncomfortable observation for someone who’s core view is negative and sees likelihood of more difficult times ahead. This is not for everyone, but also not a good time to press shorts.

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Are you gonna bark all day little doggie or are you gonna bite?

A couple considerations if you want to play it.

Utility Value

Utilities (XLU) are a classic defensive sector and have performed well this year on both an absolute and relative basis. In the last couple weeks they have been sold aggressively (like some other relative winners) in a wave of capitulatory selling.

Historically, when S&P 500 Utilities trade well below their 200d moving average there is scope for mean reversion in the coming weeks. This strikes Mr. Blonde as a low risk, measured way to have long exposure in the event of a countertrend move.

Simple SPY Call Spread

There’s likely a sexier more complicated way to trade a short term bounce, but in an effort to keep it simple here is October month end (10/31) call spread payout profile. SPY 10/31 380/395 call spread offers >3x max payout on premium for a 8% move. Sized in this table at 0.3% of capital at risk in premium is equivalent to a 5.7% delta adjusted long SPY position currently.

Given the points above and a portfolio that is significantly under risked, Mr. Blonde thinks 2-3x payout limited loss structure has value.

That’s all for now. Mr. Blonde just sharing what he sees on the screen and the clear shift in sentiment. Fundamental problems remain and the environment will remain challenging. Countertrend trading isn’t for anyone and it is certainly understandable if you don’t think its worth the risk. Good luck trading your view.

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No change in fundamental/market view held from the start of the year – Fed is hiking into a cyclical growth slowdown making for unfavorable risk-taking conditions. 2023 growth expectations are too high, but could be reset come 3Q earnings season and the Fed is now telling us they expect and accept recession. More downside needed to reach capitulation and seasonals still weak.

“Don’t fight the Fed, don’t fight the tape.” -Marty Zweig (w/ regular reminders from Ned Davis)

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A few charts and observations:

The Retest

While equity indices are retesting June lows, Mr. Blonde would argue macro conditions are worse today than they were then. 

The sharp repricing in real yields while breakevens decline historically is a pressure point for risk asset valuations.  On this measure, a new low in forward p/e is likely hence a new low in index price.

Viewed differently earnings yield vs. 10yr real yield spread sits near 5yr lows and -2 sigma vs. rolling 2yr average. Without a material change in real yields from here its unlikely there will be a durable rally in risk assets.  So far, much of he weakness in risk assets is just a repricing of real rates (i.e. valuation adjustment more than EPS adjustment).

Earnings revision momentum is worse today than at the mid-June low.  At that time, the bullish view could point to earnings expectations holding up ok, but since then analysts have marked estimates down – particularly during 2Q reporting season. We heard from FDX as well as several chemical companies there’s been a notable shift in activity.

CRB Raw Industrial Materials is one of Mr. Blonde’s preferred measures of real time activity. A basket of obscure commodities that are used to make ‘stuff’ and not widely traded on exchanges. The price shift in these commodities is mostly likely a result of demand changes.

We are experiencing one of the sharpest tightening of financial conditions (FCI) in the last 40yrs…most of which didn’t start tightening until 2Q22. The cumulative and lagged effects of FCI tightening suggest the majority of growth impact is in front of us. Some important signs are already visible specifically housing activity (i.e. new home sales)…not a small part of US economy.

MSCI AC World ex US peaked in early 2021, which was an early sign of what was coming down the pipeline. It has continued to act as a guide for S&P 500 as weak links continue to feel pressure.  New lows here join new lows in Eurostoxx, EEM, semis, transports, oil, HYG, etc.  Bottom line, new SPX lows look likely.  

From seasonal perspective, weakness usually persists into mid-Oct just before 3Q reporting season begins (i.e. JPM reports on 10/14).

Caution More Than Capitulation

S&P 500 is down 5 of the last 6 weeks, -14.2% off of mid-August highs, and retesting the mid-June low. This is a natural spot for a bounce, but one Mr. Blonde expects to be short lived and shallow. In order to get June level capitulation (-3 reading), we need SPX ~3200, +80% of stocks 20% off 52wk highs, and +30% stocks 40% off 52wk highs.

Not Your Father’s Fed

Fed forecasts are not a big part of Mr. Blonde’s framework, but the Fed’s attitude is an important consideration. Perhaps one of the biggest changes from the last 30yrs is the Fed now expects and accepts recession conditions in their forecast.  This has important consideration for present and future risk taking. Unlike past periods when growth data shows signs of weakening there will be no life preservers thrown by the Fed…you’re on your own.  Add this Fed attitude to what’s already been a ‘fast’ rate hike cycle where the odds of recession are higher.  Review this post for past Fed rate hike cycles.

In a past post (here), we outlined the earnings risk that occurs around US recession periods.  The chart below plots average S&P 500 performance around NBER declared recessions (only known in hindsight).  Many have suggested current economic data makes clear a US recession has not yet started.  This is a bearish proclamation given risk doesn’t usually trough until after a recession begins.

Bottom line, the bulk of market correction to date has been in response to rapid shift in cost of capital and correcting peak valuations. Recession risk very much remains and history suggests THE low doesn’t come until after the recession begins.

From Fed Hikes to Growth Cuts

An important, recent development is internal equity price action that suggests even wider credit spreads. This is the natural ‘next phase’ in the cycle when the speed and scope of tightening now starts to inflect some real pain. Weak balance sheet companies were performing ok, actually outperforming, into June/July period despite credit spread widening, but this has changed and should be monitored closely. Its been a while since we’ve heard the word contagion.

Just a brief note in response to recent market volatility. No change in view, stay defensive (whatever that means for your strategy) and use risk rallies to fade rather than chase.

Will follow up later this week with a few ideas to consider in light of difficult market conditions. Good luck trading your view.

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We now return to our regularly scheduled program…

This time last year, Mr. Blonde warned the Fed was embarking on a rate hike cycle into a cyclical growth slowdown and the dual tightening of financial conditions would prove to be a significant challenge to risk markets of varying type.  This year has been nothing short of difficult and is poised to stay that way for the time being.

The next phase is likely to be about corporate profit expectations. People will dismiss Fedex (FDX) as poor execution or management issue, but that is exactly what happens in weak growth, difficult times — low quality weaknesses are exposed. Expect more into 3Q reporting season.

Goodbye TINA

There have been some good news developments, like more signs of peaking y/y inflation momentum, but this is not the only risk factor facing markets.  Central banks tightening into slowing cyclical growth and likely profit recession is a significant headwind for risky assets. The spread between what’s earned in risky assets and what’s earned in 0% volatility liquid cash is approaching 25yr tights.  Goodbye TINA.

US 1yr Treasury yields offer ~4% nominal. Seems we are getting paid to wait for better days.  Please don’t talk to me about the inflation protection from equities in a year when CPI is +9% and SPX is -13%. It might be a consideration in the long run, but is meaningless concept in the near term.

Even if you are optimistic about growth and the ability of global economy to digest significant financial conditions tightening you no longer need to be 100% invested in risky, less liquid, assets when you get a competitive return from risk free cash. This should not be a controversial view.

Burning at Both Ends

Equity markets face two stiff headwinds.  When the central bank is tightening into a cyclical growth slowdown you are raising the cost of capital at the same time profit growth is fading or worse — both forms of tightening financial conditions. 

The short hand valuation model Mr. Blonde uses to guide his risk view highlights the headwind.  You can choose your own adventure in the table, but in order to get to SPX 4000 you need some pretty lofty expectations given current conditions.

Yield Curve

The recession debate has been a topic for much of 2022, particularly post April.  There remains a large cohort that believes in soft landing despite record FCI tightening and surge in energy prices (and other demand destruction inflation).  Some will tell you not to worry about yield curve inversion because a recession is still 12mos away.  Good luck with that logic. 

Also, as we’ve already been taught this year, it is critically important to extend our empirical analysis beyond 2000 or beyond favorable macro periods from 1990.  A simple study of yield curve inversions back to 1960 makes clear the need for caution.  Is today more like the 1970-80s or 2000s?  Macro regimes matter and including as many as possible improves understanding and the empirical probabilities used.

Bottom line, relevant history (i.e. pre-1990) suggests we should be worried about the message from the yield curve NOW.

Seasonals Stink

Mr. Blonde is a probabilistic thinker and channeling his inner PTJ seasonality plays a role. We can debate why or how much, but certain times of the year tend to be less favorable than others.  You can say “it’s different this time” or you can respect market’s psychological tendencies.  

The week following Sept expiration is historically the worst week, on average, of the calendar year.  This has largely held true in recent times, but we’ve seen more of the bad performance occur on day of expiration.  Forewarned is forearmed.

Beyond short term tactics, seasonality does improve as we move into mid-Oct, but has suggested in previous notes that improvement is largely born from weakness first.

Sentiment Sideshow

Literally since the first dip in January people have been citing bearish AAII sentiment as a reason to buy stocks. Of course investor psychology matters, but it often is more important in calm bull markets rather than environments with significant macro issues that need resolving. Sentiment also tends to be a conditional factor and requires good news to trigger its relevance as a contrarian indicator.

Mr. Blonde doesn’t see sentiment at a bearish extreme. A rolling 2yr z-score of sentiment surveys is not as depressed as it was in mid-June and its important to consider how long sentiment stayed depressed during difficult macro period in the 70s-80s. Maybe it won’t be the same, but its certainly more relevant to consider that as a possibility than to only use sentiment measures from 1990 (or 2000) to evaluate the range of possibilities.

Finally, when people float charts of 15yr manager surveys to suggest everyone is bearish and underweight equities, it probably makes sense to consider whether an underweight is actually a legitimate consideration given 4% 1yr Treasury yields as discussed above.

Bear Rallies

Recall the bear market rally table shared earlier this year. In mid-August in the midst of “breadth thrust” excitement many suggested the rally was too long and too large to be a bear rally. Who knows. Bear rallies come in various shapes and sizes and there are already many unique aspects of this cycle. It was a big counter-trend rally, but not as if such moves were not part of the past as well. Stay nimble and continue to fade rather than chase rallies.

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Are you gonna bark all day little doggie or are you gonna bite?

A few ideas and thoughts with now meaningful change to previously shared views here.

Broad equity markets are 10-12% off of mid-August highs but in many cases are still above mid-June lows. Fundamentals continue to deteriorate and central banks remain handcuffed by realized inflation momentum. There is nothing about the current environment to warrant above an average risk position.

Short Small Season

For market hedges and shorts, Mr. Blonde is turning his attention back to Russell 2000 which has held firm recently but entering a time of year when it tends to underperform. This weak seasonal period coincides with weak market seasonals overall as well as 3Q earnings season which is likely to shed light on the challenging environment faced by corporates, particularly lower margin, higher balance sheet leverage businesses.

Another Round in Housing?

Here’s a repeat idea. Having suggested short homebuilders from early Jan, Mr. Blonde backed off the group following near 30% relative decline into early Apr. The view at the time was the possibility of peaking rates which would serve as macro support to the group. That has not occurred and mortgage rates are making new highs at a time when housing activity is negative.

There certainly doesn’t seem to be a good reason to be long the group given current conditions. Mr. Blonde thinks a small short is warranted into next week’s data which is likely to highlight continued weakness in housing sector and likely at an accelerating rate while the Fed is on a hawkish warpath. Historically you don’t buy cyclical sectors as long as leading indicators are falling.

Cashing in on Dividends

A trade Mr. Blonde has advocated since 4Q21 is to favor S&P dividend futures as a replacement for long equity risk. The view was predicated on the risk of multiple compression even as growth would likely deliver in 2022, albeit at a slowing pace. This trade suffered in late Feb as European dividends were derisked in response to heightened geopolitical risk and the recognition of growth risk, but has largely recovered and has certainly performed better than a long SPY position this year.

But as growth risks mount dividend futures lose their appeal given liquidity profile and risk of mark down.

That’s all for now, hope you appreciate the update and perspective. If you do, please like, share, and/or comment. If you have a question please post it below for the benefit of all followers and readers.

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Shock Signs are There

We are in the middle of one of the largest rate & energy shocks of the last 60yrs and people are tripping over themselves to call the bottom.  Calling the bottom in risk assets seems misguided while Fed (and other central banks) maintain a tightening bias and energy prices are still rising at a rapid clip (see Europe which is rekt).  As suggested for months, Mr. Blonde doesn’t know if we will actually have a “recession” but you don’t need that explicit forecast for a bearish view when the risks of a significant growth slowdown are high and rising.

Stiff Headwind

Growth risk is to the downside and accelerating. Powell just told us, pretty clearly, that negative growth and “pain for households” is an unfortunate cost in battling inflation.  There is no Fed put that isn’t preceded by sharp, negative growth first.

The growth risk to corporate profits has been flagged here for some time. Recent data points, events and 2Q earnings season have done nothing to disprove this forecast.  If anything, the confidence in the forecast has increased. We can debate the precise outcome, but if 2023 earnings growth is more like -10% than +8% that is a significant negative surprise for the market to digest in coming quarters.

If you think its priced in, then you assume 2023 EPS of ~$200 and S&P 500 currently trading at 20x forward p/e.  Is that a market to buy while central banks fight inflation with rate hikes?  Value is in the eyes of the beholder, but that valuation is too rich for Mr. Blonde.

Corroborating the message above is the sharp fall in purchasing manager indices, particularly parts of the survey that lead (i.e. new orders/inventories).  As shown many times, the analyst community is not good at forecasting turning points in cyclical growth and operating leverage catches forecasters offsides in both directions.  It was an important revision tailwind into 3Q21, but is now moving in the other direction and when ISM falls into the mid-high 40s will indicate NTM EPS is 10-15% too high — repeating the message from the model above.

The pace and breadth of negative earnings revisions in response to 2Q earnings season would suggest it was not nearly as “good” as many commentators suggest.  Taking an axe to profit forecasts in response to a company’s 2Q report is hardly a feel-good story.  Growth expectations are falling and Fed tightening expectations are rising – a toxic mix for risk.

From Thrust to Bust

In mid-August, pricing chasing technicians were tripping over each other to tell you about breadth thrusts and 50% retracement of the initial decline.  They told us two months and 17% later that June low was the bottom — not really helpful.  At precisely that time, overbought markets strongly rejected the falling 200d moving average.  Apparently there’s a technical story for everyone. 

Mr. Blonde isn’t dismissing the importance of price action or the skill of technicians, but macro conditions are incredibly important in qualifying such price/momentum signals and if growth leading indicators are not improving or you don’t have a genuine change in attitude from central banks then you’re unlikely to have a change in price trend either.

Sometimes a picture is worth 1000 words…

In fact, across markets, S&P 500 (SPX) actually looks the best by a wide margin.  Equity markets ex US didn’t even come close to exceeding the local May high and remain distant from a faster falling 200d moving average. 

The quality of the move within US markets was equally questionable with a basket of US cyclicals also failing to exceed recent highs or retest 200 day average.  For specific examples from specific groups see charts of BKX (banks) or SMH (semis) as important groups failing to lead.

Stay Patient

Bear market rallies are gut wrenching events. The fear of missing out really tickles the weakest part of human brain.  We do our best to identify the risk of such evens, like suggested here in mid-June, but chasing markets higher in the face of weakening growth indicators and actively tightening central banks is poor risk management.

Even ‘good’ bad markets typically deliver a few opportunities to buy a bottom.  The mid-June event was likely just a warning shot given macro conditions described above.  The next couple months are historically the most difficult (here) and now the stage is set for another around of capitulation.

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Are you gonna bark all day little doggie or are you gonna bite?

Enough pontificating about markets below are some trades on Mr. Blonde’s radar.

Bad AAPL Seed

Single stock positions/views is not something Mr. Blonde typically spends much time opining on, but in the case of AAPL it has implications for broad markets and could prove to be a good broad market proxy.  First, the stock appears to have failed where ‘it should’ if it were going to roll over.  For a similar pattern please study the TSLA chart into late March/early April and consider how broad market’s traded Apr-May.  Second, the month of September has been a disappointing one for AAPL over the last decade…product launches and all.  

AAPL 1mo 25d put implied vol at 33, up from recent low of 25 is on the low end of the range for the last couple of years and low end of the range vs. S&P 500 (SPY).  There are worse trades if you think the market is poised for a setback, should it happen it is very likely that AAPL will be an important part of it.

Buy Low for Tight and Slow

Long low beta continues to screen as one of the more attractive opportunities on the screen.  This is a style factor that typically performs well when financial conditions are tightening and/or ISM is falling.  Both happening together is the toxic combination we have today and supports a defensive position.  Put this in the “keep it simple stupid” bucket.

Software > Semis

This pair has been in Mr. Blonde’s book since early January…frustrating to say the least as it continues to flash signs of upturn but refuses to follow through.  Sticking with the pair as relative earnings revision breadth turns positive and historically price momentum has followed.  As is often the case within markets we see momentum turn positive before you see level move.   

That’s all for now. Mr. Blonde is back from the beach and expects to post more often given market conditions.  The fundamental review remains the same, but we should expect to start to see some important divergences emerge in the next move lower and as we move into 2023. 

If you appreciate this commentary, please like it or leave a comment. If you have a question, please post it in the comment section which allows everyone to benefit from the interaction. Good luck trading your view.

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Positioning Pain

At the end of March in “From Fed Hikes to Growth Cuts” Mr. Blonde outlined his view that growth concerns would overcome inflation and pace of Fed rate hikes.  Much of this seems to have developed and certainly played a role in growth sensitive commodity sell off, rally in duration with power flattening and momentum factor unwind in equities as the macro narrative shifted.

What Mr. Blonde failed to appreciate is equity investors interpretation of inflation risk to growth risk transition as ‘soft landing’ and reason to re-risk portfolios despite various activity measures accelerating to the downside. Of course, nothing excites equity investors like a good story and inflation momentum falling to remove sideline threatening Fed fits the bill.

Of course, it’s important to monitor sentiment and positioning from a trading perspective, but growth leading indicators and fundamentals (EPS) define the trend. Bottom line, if growth leading indicators are still falling then Fed hiking at a slightly slower pace is not something that is likely to drive a durable rally.

A few observations, thoughts and ideas:

No Straight Line

Even in the worst of bear markets there are double digit rallies — markets don’t move in a straight line. The factors driving such relief are some combination of bearish sentiment, under/short positioning and often a shift in macro narrative that brings hope. Sentiment conditions were in place and something identified here in mid-June.  Did Mr. Blonde think we’d go 13% to 4150 on SPX? No, but its not inconsistent with past bear rallies.

This bear rally now looking a little long in the tooth with several controversies building that could challenge the relaxed narrative. Namely inflation proves slow to fall, China reacts to US Taiwan visit, the pace of decline in growth activity increases.

WTF did he say?!!?!

Certainly, no shortage of wordsmiths trying to decipher wtf Jerome Powell said or meant to say.  Risk taking market participants didn’t think too hard about it and reverted back to the low terminal rate mindset to boost equity valuation without much question to why the rate is lower.

Mr. Blonde is simplifying here so while likely to be precisely wrong this rationalization of recent price action is still directionally correct. In mid-June (previous FOMC), S&P 500 traded at 16x p/e (or 6.25% earnings yield) with terminal rate expectations in the 3.5-4% range. This put earnings yield 250-275bps above estimate of terminal rates. Following July FOMC, terminal rate expectations fell ~100bps and S&P 500 p/e rose to 17.4x or 5.75% which is 50bps reduction in earnings yield and a small widening in the yield gap. 

Plotting S&P 500 forward P/E alongside a policy proxy highlights the stimulative effect the FOMC shift (did they shift?) had on markets.  The policy proxy rises when inflation expectations are rising faster than real yields or real yields are falling faster than breakevens.  So the conclusion, right or wrong, among fixed income markets was a reasonably dovish shift in Fed policy prescription.  We’ll see if they stick to that script or dial it back more forcefully.

Time to ‘Pivot’?

Mr. Blonde shared this picture of NDX yesterday after posting the same chart in mid-June. Now seems like a decent time to pivot…yea, “pivot.” No reason to try to be a hero in late August as there’s a good chance markets meander until people kick the sand from their toes, but this seems like an area to add shorts (or sell trading longs).

Now Negative Carry

S&P 500 usually goes up over time.  In fact, 3mo rolling returns are positive 70% of the time since 1998.  However, if you were to choose a period of time to be defensive, under risked or short the odds suggest to do it when next twelve month (NTM) EPS rate of change and momentum are negative.  Historically, S&P 500 averages -3.7% and is down 62% of the time during periods when 3mo % change in NTM EPS is negative and falling. 

For my fixed income followers, rising NTM EPS is akin to “rolling up” the EPS curve and its what gives equities positive carry. So, when it goes negative the carry profile evaporates and equities will require rising valuation to drive performance.

Not presented here, but can review past posts for earnings view where Mr. Blonde sees high probability of negative growth into 1H23…a view held from the start of 2022.

Seasonally Soft

Coincidentally, NTM EPS is about to move into negative territory just as we enter the seasonally worst time of year to carry long equity risk. Seasonality is far from perfect, but the Aug-Oct period is notorious for above average volatility and below average returns.

Are you gonna bark all day little doggie or are you gonna bite?

Enough pontificating about markets below are some trades on Mr. Blonde’s radar.

US Exceptionalism…and Dominance

For over a year Mr. Blonde has advocated for a heavy US overweight and this continues to be the case. Don’t listen to the obsessive calls for “cheap” non-US markets. You get what you pay for in equities.  US growth will weaken, but Europe and China already in a recession and won’t benefit from weakness in world’s largest economy.  Remember, non-US markets are highly cyclical and far more sensitive to GDP volatility.  For big boys/girls, this trade is easily replicated via long ES futures and short a mix of VG, NK and MES futures.

Still Short, but Shorter Leash

Another long recommended short is consumer cyclicals. This view has largely been expressed via XRT (S&P Retail ETF) as well as short homebuilders at the start of the year.  The basis for this view was primarily over consumption of consumer goods post covid, rising cost of essentials squeezing discretionary income, and a 50yr pattern of consumer sector underperforming during Fed tightening cycles.  This remains a short, but with Fed tightening cycle reaching its later stages this trade will be on a shorter leash into 2H22.

Stay Defensive in Style

Still see tailwinds for the low risk factor, which Mr. Blonde first started recommending in late 2021.  The long/short factor trades with positive correlation to financial conditions indices and typically performs best during periods of falling ISM.  This is a defensive risk position without taking a directional view on the market.  Expect market participants to favor defensive, low risk assets as long as Fed is inflation fighting and activity indicators are falling.  Institutional players can reconstruct this trade via equity swap, while retail traders can consider AGFIQ Market Neutral Anti-Beta Fund (BTAL).

Got Gold?

Gold is something Mr. Blonde has largely avoided and certainly stayed out of the religious belief debates.  Needless to say, this has been an extremely frustrating asset for most, but now seems to have frustrated many out of a view. For context, CFTC data shows gold positioning at -1 sigma vs. 20yr avg.   Gold implied volatility is low enough (~16%) to make Sept gold calls an attractive portfolio position. 

Think they work in one of a few outcomes…1) NFP and/or CPI data is on the soft/cool side which further fans the Fed pivot excitement, 2) China counter jabs Nancy’s visit to Taiwan which further raises the specter of geopolitical risk.  Again, all in the context of unloved asset entering a historically favorable seasonal period.

SPY Hedge for the Range

A repeat idea following a bear market rally. One way Mr. Blonde is dialing back exposure and walking away from markets is to add an SPY put spread collar, which is short 430c and long 390/360 put spread. Importantly this structure has unlimited loss potential in the event equity markets rally significantly above SPY 430 level by late Sept, so this is not for everyone and you need to assess your own risk tolerance.   But this is a hedge offers a small upfront credit and fits the view equity markets have limited upside and are vulnerable to taking ‘two steps back’ as we enter seasonally weak 3Q period.

For sizing, Mr. Blonde is willing to lose 20-40bps in the event SPY trades to 430 in Sept.  At this position sizing, the structure is the delta-adjusted equivalent to -7% SPY short.

More aggressive traders may consider legging into this trade.  Buy put today, sell the call on up moves and sell the lower strike put after first meaningful move lower (i.e. >-5%).

Compounder Comeback?

And one more for those who made it this far. Early readers of Stuck in the Middle might recall the post titled “Compounding Quality” where Mr. Blonde outlined the benefits of being long high quality growth compounders vs. higher beta lower quality parts of the market. Of course this group was under attack for much of early 2022 as valuation concerns were a primary concern and portfolios were being deleveraged. In recent weeks as the market’s concern about runaway Fed hikes has relaxed and growth concerns increased, this group is starting to perform again. Worth reviewing and watching.

Get some rest and enjoy what’s left of the summer! That’s what Mr. B is gonna do.

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A few, early, earnings season charts:

It’s common for the early part of earnings season to be equity friendly with first week returns typically the best and fading as the season progresses.

Mr. Blonde can’t think of a more meaningless statistic from CNBC talking head than “% of companies beating EPS” as if beating by 1c on $3 estimate even means anything.  The chart history makes clear beating EPS isn’t what it used to be if everyone is doing it. It is now more notable when >70% of companies don’t beat lowered EPS. There is a bit more variance in harder to manipulate sales surprise, which is also running well below recent quarter trends.

A study of EPS surprise % (actual vs. estimate beat %) shows the smallest magnitude beat for first week of earnings season since mid-2020. Fading earnings momentum is an early sign of weakness.

One of the best ways to judge the quality of earnings season is evaluate how estimates in subsequent periods change as analysts digest the message from management.  Its not uncommon for negative revisions to the subsequent quarter during earnings season, but slope of negative revisions for next quarter has steepened.

Negative revisions are not isolated to the next quarter with both 2022 and 2023 estimates coming down, especially when excluding the energy sector.  However, even energy is likely to be a drag now with oil prices more than 20% off of highs.

During earnings season its useful to monitor 1mo revision trends which encompass the period around and during reporting season.  See below, but it’s a sea of red.

Perhaps one of the most comprehensive ways to judge earnings season is by broadly studying stock price reaction to reports after dispersion adjusting results. Big misses (i.e. >-2 sigma) have been hit harder than big beats are rewarded. This is not uncommon but the gap has widened in recent quarters and continues in 2Q22 so far.

The above stats will change after this week given the number and size of companies reporting. Mr. Blonde’s bias for disappointing results remains and recent data trends are now clearly confirming a weak profit outlook he flagged in 4Q21.  Unfortunately it will get worse before it gets better.

In addition to the pressure coming from tighter financial conditions and rising business costs, its important to consider how far above trend EPS is coming into 2022. The backdrop is unlike profit growth slowdowns from 2010-2018 which were far less extended.  The higher the rise, the harder the fall is a risk as many companies are over earned. The extension of NTM (next 12mo) EPS above trend also makes it difficult to be confident in valuation based on this figure.

Bottom line, future estimates are untrustworthy at best during periods of significant negative revisions. And as mentioned here in the past falling NTM EPS is a rare event and results in stiff headwind for equities to overcome.

The stats above are for the US, which remains the most important and profitable region in the world by a country mile.  Rest of world, particularly Europe and EM, have failed to generate any meaningful earnings growth in over a decade and its unlikely to change in current backdrop.  The PMI cycle hurts global profit growth, but historically impacts cyclical geographies with greater force. So remember when they tell you to buy non-US because its “cheap”…you get what you pay for.

That’s all for now. Still on track for stiff fundamental headwinds that significantly limit equity upside and serve to significantly limit scope and duration of equity rallies.

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2Q22 Earnings Season Summary:

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Disclaimer

No new broad market view here, just updating the next phase which is focused on EPS cuts and the realization of significant growth slowdown.  The “R” word is being used more frequently which reflexively makes it more likely as corporate and household behavior shifts defensive. S&P 500 profit and price Recession downside risk was outlined here.

Posting a data driven, unemotional, index from @NancyRLazar1 to make the point that recession odds are way up and historically don’t reach this level without delivering one.   

Risk markets have certainly contemplated recession, especially in the last couple months, but are not fully priced for one.  Consider the average peak-to-trough decline in S&P 500 during the ’70, ’74, ’87, ’01 recessions was -39%. At face value, the current -24% drawdown suggests the market assigns 61% probability to such an outcome—coincidentally similar to Nancy’s way more data intensive indicator.

Bottom line, it can and will likely get worse before it gets better…which brings us to 2Q earnings season.

Summertime Blues

2Q earnings season is unlikely to deliver many good headlines. Mr. Blonde’s broad assumption is the season carries mild asymmetry. Expect more meets than beats, but even the beats are likely to face downbeat commentary into 2H.  Companies that miss will be punished.

This pattern was already evident from recent earnings seasons but given the macro backdrop and time of year (summer trading volumes) it’s a challenging setup.

2H growth expectations have come off a touch since first highlighted here, but are still way too high given deteriorating growth momentum and the consequence of higher input costs and tighter financial conditions.

Analysts seem to be getting the message with estimates coming down across the board.  In fact, 2023 consensus EPS has now fallen from $250.2 to $247.7, which doesn’t sound like much but its rare for out year estimates to be lowered.  And excluding the energy sector the cuts have been sharper.

Table with a lot of numbers maybe too much for some, but it highlights the sea of red that is numbers cuts.  Very few groups are spared with the exception of energy, but the 27% fall in oil prices isn’t likely to drive many to take numbers up there either.

For the macro, fixed income followers EPS growth and revisions are what make equities ‘positive carry.’  You want to buy upward sloping EPS curves (i.e. roll up the EPS curve), but as revisions turn negative you are left with little/no carry and reliant on p/e expansion to drive returns, which is unlikely if numbers aren’t going up.  Side note: the lack of ‘positive carry’ is why non-US markets have stunk for the last decade despite perennial calls to buy ‘cheap’ non-US markets.

We started 2022 with peak liquidity, peak valuations, and peak earnings. We’ve made progress on liquidity reduction and valuation compression, next up is meaningful reset in earnings expectations.  Mr. Blonde expects this to be the finishing move taking S&P 500 toward 3000 level (i.e. ~15x $200) at which point it will be easier to say the market is priced for a profit growth recession.  The pace of earnings correction will happen more slowly over time (i.e. death by paper cuts), but as previously documented S&P 500 price consistently bottoms 9-12mos ahead of the EPS bottom.

Wen Moon SPX?

Mr. Blonde was recently asked what signs/events to watch for a low in equity risk. This is a unique cycle and its dangerous to be dogmatic, so consider this a pre-mortem exercise rather than an explicit forecast.

The Sept-Nov time period represents an interesting window of time for the low to be set for a few reasons:

• calendar seasonality into mid-term election year,

• would expect ISM <50 completing 18mo down cycle,

• expect visible signs of growth slowdown and labor market deterioration which could bring tone change from Fed,

• 2023 outlooks slashed as corporates (and analysts) throw in the towel,

• we know S&P 500 price bottoms 9-12mos before EPS bottom (3Q23?).

Don’t get too excited its just a thought experiment in an effort to stay aware and forward looking. As you can see from the list more bad things need to happen.

That’s all for now, not major change in defensive market view.  The relief called for in early June is passing its expiration date as we achieved the 6-8% average bear market rally over 15 trading days…more like 6.7% in 5 trading days actually.  Will follow up with some trade ideas and stock screens. Good luck trading out there it’s a war zone.

Thanks for reading, please provide feedback by liking, sharing, commenting.

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Disclaimer

The best way to describe the trading environment is one step forward two steps back. Fortunately, we are currently moving one step forward after a nasty, swift fall from late May. 

As previously noted, trading against one’s core view is not easy and not for everyone, but if you can avoid sharp bear market rallies it eases anxiety and allows for better entry points on shorts. 

1 step forward, 2 steps back

A potential turning point was identified at the start of this week.  Oversold conditions, depressed sentiment, and some signs of behavior change during the June correction all led Mr. Blonde to believe we could bounce. 

So far the move has is directionally uninspiring, but tone has shifted somewhat and some big internal rotations as we shift “from fed hikes to growth cuts” narrative. Weak growth isn’t good, but happens more slowly and is more easily digested by equity investors than a series of 75bps rate hikes.

Best guess right now is the bounce can last into early July. More on seasonals below, but they tend to be strong through July 4th week. Then expect anxiety over 2Q earnings season to increase. SPX can rally to 3950 before hitting its 20d avg and stays in firm downtrend.

How far we go is anyone’s guess, but the average bear rally is 7-9% and occurs over ~15 trading days.  They are often violent affairs and the moves in the more stressed parts of the market are way above average (i.e. short squeezed).

Closer to Capitulation?

Another reason Mr. Blonde got interested in the possibility of a bear rally was finally reaching historically important threshold of -3 after the correction in energy, utilities and staples groups as well as the further fall across the market.

Could it go more? Sure. Will it? probably, but can’t be too dogmatic and need to swing at pitches to get on base.  The models are there for a reason and designed to guide, reduce emotion and improve judgement.

Historically, buying equities after the first -3 reading has proven a good 6mo entry point with a few exceptions—only Madoff has a model with 100% hit rate.  The longer your holding period the more relevant the signal.

In Mr. Blonde’s judgement we will dip below the -3 threshold again and likely reach lower readings, but appreciating the progress made to date is important and can’t be too dogmatic.

Narrative Shift?

Also catching Mr. Blonde’s eye recently is the shift in market internals and correction drivers.  Consistent with the opinion that the narrative will shift “from Fed hikes to growth cuts” as the year progresses the parts of the market that led the correction were more GDP sensitive and less Fed/rate hike sensitive. 

An imperfect, but relevant, measure and certainly topical is the relative performance of secular growth vs. cyclical growth stocks.  Secular growth stocks will carry higher absolute valuations given growth, profitability, and volatility of growth characteristics where cyclical growth stocks often have high beta to GDP and tend to trade with lower absolute valuations. 

MSZZGRCY Index actually turned up during the June correction and after leading SPX lower from Sept of last year.  This is a change and one that fundamentally makes sense as market shifts towards earnings risk from valuation risk.  Also notable how oversold this ratio is relative to recent trend and the full retracement of outperformance from 2016.

This change in behavior doesn’t tells us much about the direction of the market, but a change in character and potential change in leadership is important to monitor and can be an important signal about what the market thinks comes next.

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Recession Risk Pricing

Mr. Blonde has already communicated his view that growth is slowing (here, here, here). Increasingly the debate has shifted to how much slowing and when is the market priced for “recession.”  A few historical observations on this and then will provide a best guess at what SPX level fully discounts a recession with the caveat that history doesn’t repeat but often rhymes.

• EPS declines around recessions are reasonably consistent at -17% from peak.  2008 was more the exception than the rule given the nature of crisis (i.e. financial sector write-offs). 

• EPS trough often comes at the tail end of the recession or more likely after it is over

• S&P 500 price trough is generally 9-12mos before the EPS trough

• LTM P/E at the price trough is ~12x, but 14.5x post 1990

• The price trough on trough EPS (only known in hindsight) was ~13.5x and ~16.5x post 1990

• The 1953 recession occurred after an earnings recession, so its excluded from the valuation trough stats

Great, so what does that all mean.  Current S&P 500 LTM EPS is $216.  Rolling out of lower 2021 EPS and moving forward a couple quarters should result in an LTM EPS of ~$223.5, which we will assume is peak LTM EPS.  If EPS falls 15%— a bit better than the median drawdown —then we end up with $190.  

12x $223.5 = 2682

14.5x $223.5 = 3241

Averaging the two results in a S&P 500 price trough of ~2950

13.5x estimated trough EPS of $190 = 2560

16.5x estimated trough EPS of $190 = 3130

Averaging the two results in a S&P 500 price trough of ~2850

EPS Check

First, is $190 a reasonable trough EPS estimate?  Well Mr. Blondes earnings growth leading indicator which he’s been sharing for months to war of impending profit slowdown and likely profit recession suggests S&P 500 is at risk of falling 13% in 2023 vs. year ago levels.  That’s pretty close to the typical 17% EPS decline during past recession periods.

The message from ISM falling to 50 or a bit below as consistent with recession conditions would suggest NTM EPS will miss expectations by 15-20%. Current NTM EPS is $238 and a 20% miss would equate to $190. Go figure.

Finally on earnings, they are currently running well above trend. During US recessions of varying type its common for earnings to revert to trend if not fall a bit below.  Considering the growth rate in trend it would indicate LTM EPS mean reverting toward $170-175.

Is the Price Right?

So, is ~2900 a reasonable target to price in a EPS recession?  That would represent a 39% decline from peak price and put this period on par with 1970 (first inflation wave), 1974 (inflation driven recession), 1987 (liquidity shock), and 2001 (TMT bubble w/ mild recession).  Each of these periods has been referenced in the last year as a possible analog, so its not just random but they also averaged a -39% peak/trough decline.  Go figure.

Are you gonna bark all day little doggie or are you gonna bite?

A few portfolio ideas Mr. Blonde is focused on.

Embrace the Bear Rally…for Now

For starters, Mr. Blonde reduced shorts and has layered in some long risk with the view oversold markets can frustrate bears for the time being. In addition to the points made above, the seasonal window into the July 4th holiday week tends to be one of the better times of year.  Admittedly its always difficult to put much weight on seasonality and even more difficult in fundamentally challenged years.

If you don’t like the directional play, then long NDX/short RTY is interesting and consistent with narrative shift “from fed hikes to growth cuts” given the growth cyclicality difference between indices.  NDX has been the focal point of the last 6mo’s correction and if narrative shifting as mentioned above we could see focus shift toward leveraged balance sheets and recession concerns.  Generally speaking, pair trades are better for the current environment.

Shifting Narrative

In From Bad to Worse, Mr. Blonde studied historical periods of falling ISM and rising core CPI as a proxy for stagflation environments, or at least environments that had that feeling.  We are now shifting to an environment of falling manufacturing ISM and falling y/y core CPI.  Such environments are less negative, but still weak for cyclicals/defensives and still favor defensive allocations.

A equity trades Mr. Blonde likes that fit with the history summarized above:

Software > Semis.  A clean, sector neutral way to play a shift back toward secular from cyclical growth is long software and short semis. This view has been shared already here, here, and here.  Mr. Blonde likes that the pair held early 2022 support and now as macro narrative shifts towards peak inflation and growth concerns it favors such a rotation.

Utilities.  Nothing particularly exciting here, but utilities sector sold off hard in June into multi-year uptrend support and now coming off oversold levels.  The table above flags utilities as one of the best performing sectors during periods when both ISM and core CPI are falling.  Seems like a good, defensive way to add long exposure for a trade. 

Not discussed above, but still like keeping a small long duration position in the books with the opinion the worst of inflation momentum is behind us and the Fed will get what it wants at the expense of weaker growth outcome. Maybe yields won’t fall alot and we are in a new regime as so many now believe, but its unlikely they are going to rise much as growth slows and recession probabilities rise.

That’s all for now. If you appreciate the work please like, share, comment.

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You won’t find doom and gloom, nor will you find rainbows and unicorns.  The focus here is data-driven framework to engage and profit from markets for what they are, rather than what we think they should be. If you appreciate the work, please like it, share it, comment on it. If you have a question, please ask it.  The interaction benefits all.

Stuck in the Middle

A couple weeks ago Mr. Blonde posted Ripe for Relief and reaffirmed that view in late May (here).  By all accounts various measures of risk relaxed since and focus shifted to how far the bear market rally might go.  At the moment, we seemingly find ourselves stuck in the middle of a downtrend and approaching resistance as we’ve met average bear market rally criteria. 

Mr. Blonde sees equity markets as having limited upside given his profit growth forecast (negative growth in 2023) and valuations that remain above average given macro conditions (inflation and Fed hikes).  The one step forward two steps back mindset for markets remains and it’s time to start walking away from the recent rally. 

To move us from the middle the market will need new information on inflation trends where softer readings can push us higher and higher readings are likely to bring back some rate volatility to send equity risk lower. But time is also a key now as we need to digest weaker growth and profit trends over the next couple quarters.

What is a Bear Rally?

Bear markets are a function of price, time and breadth.  Over the last 50yrs there are only a few bear markets, so small sample size reduces ability to have high confidence in how it plays out.

The table summarizes bear market rallies as defined as at least a 5% rally from one month low.  The rallies are relatively frequent and often violent affairs lasting 13-15 trading days on average and delivering 7-9% counter trend gains at the index level.

Bottom line, the current rally of 7% over 9 trading days meets the average criteria of bear market rally and so we should look to dial back risk exposure.  After anticipating relief, Mr. Blonde thinks it’s time to start walking away from risk. 

Now What?

There are two clear risks on the horizon that can end the calm. A turn in rate vol and/or a pick up in negative corporate guidance into 2Q reporting season.

Quick recap of how we got here to help us understand what happens next. The relief came from lack of upward repricing in expected Fed rate hikes as faint signs of peaking y/y inflation, more signs of softening activity, and Fed suggesting 75bps might be more than necessary at the moment.  Basically, the market got comfortable with the committed rate hike plan and as a result rate volatility faded and allowed equity valuation to stop compressing.

The equity valuation compression in the last 6mos is meaningful and now finds itself in pre-covid average range of ~15-18x.  Is that too high? Probably given macro conditions of inflation and fed rate hikes, but its also come a long way from 22x late last year.  Also notable, at least from tactical trading standpoint, is valuation undershot the -2 sigma band by an amount similar to past corrections which brought a pause in the pain. 

It’s unlikely valuation can expand given the combined headwinds of Fed tightening cycle and negative earnings revision trends.  In Don’t Fight the Fed, Mr. Blonde outlined what happens during Fed tightening cycle but importantly segmented fast and slow cycles to highlight important differences.  This is a fast cycle.

But its not just the Fed, valuation compression is the norm when earnings revision breadth is falling too. The combo of Fed hiking into a profit growth slowdown has been a core view for Mr. Blonde since 4Q21. 

The market focus and narrative is now transitioning From Fed Hikes to Growth Cuts. Profit growth is the oxygen that allows risk markets to breath.  If it is in short supply, they are weak and slow, if it goes deeply negative, they die.  

Mr. Blonde’s macro growth composite dipped into negative territory and given the long lead time of the earnings growth leading indicator suggests it will keep falling.  You can read here how Mr. Blonde uses the growth composite when facing markets – it’s a key performance indicator.

But “GDP is good and the economy is not in a recession”. This is the dumb stuff gray haired strategists say that don’t actually take risk.  We don’t trade GDP futures so don’t make that a big part of your risk taking investment case.

Brace for Impact

The market’s current expectations for 2H earnings growth appear wildly optimistic.  Consensus forecasts call for S&P 500 EPS to growth 10% in 2H22 vs. 1H22, which compares to long term median of 4.7% 2H growth.

Not only is the expected growth way above seasonally adjusted 2H growth, but it flies in the face of a macro growth environment that will surely be weaker than 1H as the global economy digests the triple threat of tighter financial conditions, higher input costs and fading cyclical growth.  The probability of negative guidance and EPS downgrades during 2Q earnings season is not trivial.

At the industry group level, consider some of the growth expectations here and ask yourself if this is a sensible forecast given the current and expected macro conditions.  Hint: it’s not.

Its Just Math

The combination of higher cost of capital and flatlining-negative profit growth represents a significant headwind to equity markets. Mr. Blonde’s equity market valuation framework is fairly straight forward and presented in the table/chart below. Given the weak EPS growth forecast there is no upside for equity markets without a significant shift in cost of capital (i.e. lower rates for the right reasons) with current BBB cash credit yield of 4.7%.

Of course no valuation framework is perfect or precise, but can serve as a good guide and keep our emotions to a minimum. 15-20% downside to “fair value” is too much to ignore.

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Are you gonna bark all day little doggie or are you gonna bite?

A few portfolio ideas Mr. Blonde is focused on.

SPY Structure for the Range

One way Mr. Blonde is dialing back exposure and walking away from markets is to add an SPY put spread collar, which is short 430c and long 395/375 put spread. Importantly this structure has unlimited loss potential in the event equity markets rally significantly above SPY 430 level by mid-July, so this is not for everyone and you need to assess your own risk tolerance.   But this is a hedge with small upfront premium and fits the view that equity markets have limited upside and are vulnerable to taking ‘two steps back’ as we enter 2Q earnings season.

For sizing, Mr. Blonde is willing to lose 30-40bps in the even SPY trades to 430 by late June.  At this position sizing, the structure is the delta-adjusted equivalent to -5.5% SPY short.

Still Like Buying Some Bonds

Since the end of March, Mr. Blonde has been looking for US 10yr yield to peak in the Apr-May time frame which is consistent with seasonality and fits his view that narrative is shifting “from fed hikes to growth cuts.”  While far from perfect, the stall in yields in the last several weeks as well as the re-emergence of negative correlation between stocks/bonds gives some credence to the view.  It’s likely to be a battle, but the divergence between yield levels and macro growth trends suggests the asymmetry favors lower yields at some point over the next 6mos.  Time will tell.

Soft over Semis

Within equity markets, Mr. Blonde is looking for opportunities to buy beaten down growth segments that can find relative relief into 2H22 as the market concern shifts “from fed hikes to growth cuts.”  During periods of slowing and eventually negative growth trends, equity markets typically favor high profitability, durable growth stories and focus less on the valuation paid for this growth security. 

One representation of that is to be long software and short semiconductors, which historically moves with ISM manufacturing cycle (i.e. growth proxy).  Without a doubt, the software sector was popular and correctly derated and derisked as it became clear the Fed was hiking us into a growth slowdown. But from here, semis carry increased risk as consumers pull back on durable goods spending and semi inventory levels are left vulnerable at time when sales growth is decelerating.  If you wonder what this means, please see recent reports from WMT and TGT.

Meanwhile, the software group has acted better recently.  Recent earnings reports from PANW, ZM, INTU, SPLK, ADSK, ZS, CRM, S, MDB, PATH, OKTA, and CRWD highlighted double digit sales growth continues and stock price performance of each outperformed the market in the days surrounding the report date – a healthy development relative to prior quarters.

Quality Compounders

Kudos to Goldman Sachs for cracking the code on defensive compounders that outperform S&P 500, particularly during periods of strong performance from the quality factor, which Mr. Blonde has favored since 3Q22.  Even more impressive is the GS basket (GSXUCOMP for those with institutional access) of 57 stocks has no exposure to the energy or financials sectors and still managed to beat S&P 500.

The selection criteria focuses on sales growth variance, profit margin level and variance, profitability, and FCF yield.  Per GS, on average, the stocks in the basket generate 7.1% revenue growth and 15% earnings growth over the past 10 years (compared to S&P’s 5% revenue growth and 8% earnings growth) with high FCF conversion.

Mr. Blonde expects this basket to continue to outperform as market earnings growth continues to slow and ultimately dips into negative territory in 2023.  See other similar periods boxed in the chart below, but outperformance cycles here typically last 12-24mos.

Stocks in the basket Mr. Blonde also owns include SPGI, MCO, NOC, LMT, MO, UNH, ABBV, EW, ISRG, COST, MCD, GOOGL, MSFT, ADBE, and VZ.

That’s all for now, thanks for reading. Please comment, like, share if you appreciate the work. Good luck trading your view. -Mr. B

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Disclaimer

In this post, Mr. Blonde puts the correction into context and summarizes oversold conditions leaving markets vulnerable to some good news.  A precise catalyst is not always easy to identify, but Mr. Blonde sees inflation momentum passing its worst, rate markets calming as the most hawkish Fed scenarios are being removed.

Time horizons and risk tolerances differ greatly. Mr. Blonde expects the relief rally plays out over the next 4-6wks and on a risk scale of 1-10 (10 is max risk) this is a move from 2 to 4 for Mr. Blonde. It reflects the view major equity indices can rally 10-12% and still be in a clear downtrend so the risk/reward has shifted somewhat.

Correction Context Matters

The graph and table below summarize 2yr rolling drawdowns in S&P 500. 20% corrections are not unheard off and often happen outside of significant economic corrections (i.e. recessions).  In Mr. Blonde’s view the summary stats here suggest equity markets met the minimum criteria for cyclical bear market and priced in ~80% odds of a ‘normal’ recession (i.e. -18.7% / -21.6% median correction during recessions).

Of course, corrections are a function of both price and time.  Even if price damage has considered the direction of growth, it will take time for the severity to be evaluated and digested.  Inflation constrains central banks’ ability to pivot and provide liquidity, so we are on our own until realized inflation is clearly lower…which will certainly take time.

This historical summary is far from perfect and has the benefit of perfect hindsight. The point here is to measure today vs. past periods as we consider future outcomes. Bottom line, meaningful damage already done and being more bearish today than 6mos ago is probably inappropriate even if the correction has further to go.

Point of Exhaustion?

Nasdaq 100 (NDX) represents a significant portion of broad market and has been a focal point for many.  NDX has now fallen 20% over 7 straight weeks, retraced 50% of the rally from Mar’20 low, test of 150wk average, oversold 14wk RSI and forward valuation that has reverted to pre-covid average.  This combination seems like an appropriate time for some relief.

Growling Bears

Stories about recession and/or bear market have increased meaningfully recently. This is simply a reflection of popular stories in the news and therefore a reflection of market sentiment. 

Sentiment Signal?

Mr. Blonde has been reluctant to rely much on sentiment surveys given his fundamental view and expectation for a proper correction this year.  But sentiment has darkened recently and its tempting to lean against the negativity.  When measured over the last 30yrs the current level of sentiment is bearish and led to higher stock prices 4-6wks later with a high hit rate. 

Mr. Blonde’s sentiment measure combines both AAII and Investor Intelligence (II) surveys and normalizes over rolling 2yr periods.  In addition, he limits observations to periods when sentiment is falling to avoid periods when sentiment is low and already rising.

Of course there is risk of false positives given the macro conditions, but 30yr historical probability of higher prices in 4-6wk are hard to fight.

Positioning Purge

The mistake earlier this year when using bearish sentiment to suggest buying the dip was positioning had not yet really reflected the negativity.  This has changed in the last couple months, particularly among long only investors.

First, while imperfect the BofA Global Manager Survey is a decent measure of sentiment among institutional investors with proper history.  Cash balances among institutions is the highest in 20yrs. Of course this makes some sense given the lack of protection provided by duration, but also reflects bearishness.

Second, and particularly interesting to Mr. Blonde, is the recent capitulation among retail traders. GS team estimates retail traders have sold ~50% of what they purchased in 2020-2021 period.  Its notable that this really began following the bounce back rally in March and explains the persistence and magnitude of the sell off since then. 

Capitulation Conundrum

Deep capitulation remains somewhat elusive as Mr. Blonde’s preferred measure has not breached -2.5 despite a deep sell off in equity risk. Historically, a reliable buy signal comes when the indicator falls below -3. 

A closer look at S&P 500 industry groups highlights which parts of the market are keeping us from reaching a capitulation buy signal. Energy, staples, utilities, and insurance which account for ~15% of market cap and 20% of stocks in the index are the resilient bunch resisting sell off.  Interestingly, staples started to join the puke party last week.  A close eye on these remaining groups is warranted their day will come too.

Even during big bad 1970s…

Mr. Blonde’s is skeptical of the 1970s style inflation/regime comparisons, but that’s besides the point.  Even if this were the 1970s scenario please keep in mind that the level of inflation didn’t matter as much as the direction of inflation when it came to trading markets.  Too often Mr. Blonde hears people worry about inflation not getting back below central bank’s 2% target as a reason to be bearish and concerned.  Time horizon matters here and while that concern might be valid for 5-10yr holding periods all that will matter in the 12-24mo period is the direction of inflation. 

We are likely passing the worst of inflation momentum (i.e. y/y) and if the market starts to believe this it can remove the more hawkish scenarios and act as a positive development for markets. Of course we have other issues to deal with, namely profit downgrades, but inflation is an important one that can shift sentiment and bring relief.  April PCE on 5/27 is the next signpost.

Inflation is a lagging indicator and follows growth. Not for today, but this is why Fed policy and markets are so out of whack today. Instead of looking forward, Fed decided to put all its policy chips on the most lagging indicator of them all.  Mr. Blonde has made clear his view of slowing PMIs for many months and more people now agree.  What follows lower PMIs is falling y/y inflation momentum.

That’s all for now. Equity markets are oversold and certainly embraced the bearish narrative over the last couple months.  We’ve been rewarded for being defensive and bearish and Mr. Blonde simply sees this as a reason to take some short chips off the table and add some tactical, limited loss longs (i.e. QQQ calls). Good luck out there.

Markets ‘feel’ ripe for some relief. It’s a trading view rather than a change in fundamental outlook and the ‘feeling’ is based on judgement supported by data-driven observations. It’s an opinion that markets may have moved to far too fast and are bracing for bad news that may take longer to develop than currently priced.

For Mr. Blonde this means trading against his core view so its a small change to exposure and maintaining defensive posture just a little less so. The US CPI report is a clear catalyst and swing factor that will either make this judgment look stupid or genius, but Mr. Blonde’s inflation indicators suggest slowing momentum. It may not be evident in tomorrow’s report, but think its worth risking a little in case it is.

1 step forward, 2 steps back

First, Mr. Blonde is no technician, but the NDX price chart looks to be a  natural spot for some relief even in the context of a downtrend.  Also interesting and despite all of the focus on NDX as a giant bubble is the relative performance of NDX to Russell 2000 which is hanging onto a still rising 200d avg. 

Sour Sentiment

Bearish sentiment is a necessary but not necessarily sufficient factor for buying risk. Mr. Blonde uses a combination of AAII and Investor’s Intelligence (II) sentiment surveys to study the efficacy of bull/bear sentiment readings historically. It’s true over short time horizons (i.e. 1mo) that bearish sentiment is generally a good contra-indicator. This is primarily because sentiment follows price and it indicates oversold conditions.  As always, judgement is required but the starting conditions present some margin of safety.

Its the Economy Stupid

Further evidence of sour sentiment as well as realization of Mr. Blonde’s view is the weakness in cyclical/defensive ratio. For all the talk of great nominal GDP growth, strong household balance sheets, and commodity super cycle the outperformance of low beta defensive sectors has been significant and is anticipating a difficult growth environment.

Capitulation?

More signs of capitulation recently, particularly the shift in equity fund flows. Is it enough? Maybe enough for the time being until we start to see the growth impact from tighter financial conditions and more material markdown of profit growth expectations. Certainly the market has entertained that view over the last month, but the confirmation could be what drives capitulation to its completion. 

Historically, as presented in the table more durable, capitulatory bottoms are typically found with first readings <= -3.  For the time being a reading of -2.3 coupled with bearish sentiment and oversold conditions is enticing enough to dial back shorts and tactically increase exposure. If you have been holding heavy cash position this seems like a good place to add some risk.

Inflated Expectations?

The most obvious catalyst to lean against the bearish sentiment is evidence that we are passing the worst of upward inflation pressure.  Inflation is kryptonite for expensive markets as it forces the central bank’s hand irrespective of growth conditions.  Inflation will continue to be an issue, but if it’s perceived to be less of an issue it can bring some relief.

Final Word

Trading against one’s core view is not easy and not for everyone.  Mr. Blonde’s fundamental view for profit growth momentum to slow meaningfully as the year progresses and turn negative remains.  This is a tactical view and recognition Mr. Blonde’s view is no longer in the minority. He still expects market narrative to shift “from Fed hikes to growth cuts” as the year progresses and will continue to cap upside in risk markets, but doesn’t preclude them from going up for periods of time.

To put the view into context, on a risk scale of 1-10 (10 is max risk) this is a move from 2 to 4 for Mr. Blonde but major equity indices can rally 10-12% and still be in a clear downtrend so the risk/reward has shifted somewhat.

Good luck trading your view.

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