Still Ripe

oversold conditions, bearish sentiment, and shift in positioning leave markets vulnerable to good news

Following on from “Ripe for Relief” this opinion is tactical and not a change in fundamental outlook, which remains challenged. Market probabilities have repriced and acknowledged the risks warned about coming into 2022: peak liquidity, peak valuation and peak profits. There is more to go, but window is open for a breather.

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.