If you subscribe to our paid service, then you know that on Tuesday last week I called the S&P 500 dropping swiftly to 2100. Here’s what I said:
I think the S&P is going about to test 2,100 (a 3%+ drop)
First, the support is gone from Apple and Oil.
This is a technical thing.
Apple: Apple is 3.5% of the S&P 500. A good rule of thumb is that, for every $1 move in Apple, the S&P 500 moves 7 points. From the end of June to today, Apple has risen $14 and added ~100 points to the S&P. But during that same time, the S&P has risen only 80 points.
Without Apple, the S&P has fallen.
Meanwhile, oil is turning wobbly. West Texas Intermediate (WTI) Oil prices have fallen from $48 to $45.
That’s partly from the strong dollar (up 2%) but really it’s from fundamentals. Some are specific to oil: lack of production freeze, for example. And today it was revealed that 1H demand was actually significantly lower than previously reported.But overall, there seems to be recognition that there is no rebound coming in the 2H.
And that’s the second thing I’m seeing. 2H guidance on earnings calls continue to be wobbly and weak. And the market is moving sharply when disappointed.
This past Friday, it happened almost exactly as I predicted. The S&P dropped 2.5% (or 54 points) to 2128. It bounced Monday on a dead-cat bounce (a slight recovery after having fallen so hard. A dead-cat bounce is usually followed by another leg down), only to drop back again this week.
The scary part – and the part you really want to know – is that Apple rose $2 – which translates into a positive uptick of 15 points. In other words, the S&P crash excluding Apple was even more severe.
But even AAPL’s drop is within a broader context that the market is just incredibly disconnected from underlying fundamentals. At a time of falling profits and slowing economies, there is absolutely no reason for stocks to be pressing the envelope of higher price-to-earnings (P/E) valuations.
It is why the market will likely head one way… down.
In fact, the last few days is just the beginning.
Companies like Ford (F) have already begun to guide profits down. The market is no longer discounting these warnings, no longer looking past the steady drumbeat of bad news, and has begun to price in weaker-than-expected profits in the second half.
Another factor is that a broad short squeeze has ended. A short squeeze is a fairly common situation and is the opposite of a fire sale: instead of everyone dumping shares and the price gets “w-a-y-y-y ‘oversold, a short squeeze is when there is a crowded short trade that moves against the shorts and they have to spend a lot of money buying back the shares.
A great example of a short squeeze was in October 2008 with Porsche and Volkswagen (VW). It’s been called the mother of all short squeezes. A short seller is someone who is betting against (in this case) a stock. But they do it in a unique way. They borrow someone else’s shares and guarantee that they will return those shares at some pre-determined date. They pay a ‘rental’ fee and then sell those shares at today’s prices. Their bet is that the price will drop and they can buy-back the shares but at a much lower price.
At the time, VW was owned 20% by the government and 80% by the market. And lots of shorts were betting against the stock. Overnight, Porsche revealed that it owned 42.6% of VW and had options to buy another 31.5%. In other words, Porsche had cornered every single share of publicly traded VW. That meant that only 5.9% of VW’s shares were available for trading.
The price surged. And then surged even more as shorts scrambled to close their positions. The price went from $265 to $1,300 – a gain of nearly 400%. Countless firms faced bankruptcy and many stock exchanges looked for ways to save their clients by calling the Porsche deal fraudulent. (Basically the world of Goldman’s had a winning hand and went all in and then piled in tons of “IOUs,’ only to have Porsche flash a Royal Flush and demand payment.)
Now, imagine that a lot of firms bet that the stock market would dip over the Summer only to find out that it moved up. And kept moving up. Finally, these shorts had to close their positions by buying the stock market, sending up the price even more.
Happens all the time, in both directions.
A short squeeze forces sellers to become buyers.
But, like a fire sale, it eventually dies down. And without the extra buying pressure, prices recede.
That’s the background as we entered September.
Basically, this means that the market was over-bought and ready to pullback.
One trigger for the sell-off is the Fed’s meeting September 20th. There’s a saying that, for the markets at least, bad news is good news. In the recent past, bad news meant the Fed would continue a loose monetary policy. Markets love free money.
That’s no longer the case.
These days, bad news means the economy is slowing and there’s a recognition that the Fed has no ammunition to get the engines revving again. We’ve reached the limits of what monetary policy can achieve insofar as it affects the real economy. Worse, monetary policy is no longer just ineffective, it’s possibly dangerous: the continued threat to raise rates at a time of slowing growth is policy error and has no market support.
Well, the Fed meets in five days to vote on a rate hike, which leaves a week for investors to position. The collapse is a sign that the markets have lost faith in the Fed.
Last, the recent run had no support. The volume of shares being traded on a daily basis was close to a cyclical low. That’s another reason why the short squeeze was so impactful: there wasn’t a lot of other action. The market was moving up on fumes… just ripe for real money to bet against it.
What Happens Next
Some investors are asking whether last Friday’s selloff was a good time to “buy the dip.”
The answer is no.
Look, the market is up 10% year-over-year (yr/yr) while sales and profits have crashed during that time.
I could argue for a 5% rise, or 2,100. (Hmmm, where have we seen that figure recently….)
But that 2,100 would be a year-end figure, and December is months away.
My sense is more downside ahead.
First, there’s the Fed fear that will dampen any moves. (No rate hike means the Fed is worried about the economy, a small rate hike is meaningless and actually insulting because it looks symbolic, and a rate hike will throw everyone into panic.)
Between now and that meeting, macroeconomic data is limited to a retail report next week and some news from China.
Second, there’s a desire to lock-in profits. For most money managers, the clock stops in October, so this is a good time to start cleaning up the portfolio.
Another data point to consider is that the slide on Friday never stopped. It was straight down.
Nobody came in and bought on the hopes of some rebound. Instead, everyone accepted the drop and as the bell approached, the selling took off in earnest: another 1% drop in the last 30 minutes of trading. On Tuesday, the market just dumped and didn’t look back.
Asset Allocation
Now, if you’re like me, you got out into cash a while back. You missed the run up… but you also missed the drop back down.
The basic problem is that all asset classes are moving in sync: bonds, stocks and gold both move up.
That will break eventually. But when and how? After all, the various central banks have spent tens of trillions of dollars to prop up the markets.
They aren’t going to back off now.
Here is how I’d position a portfolio from a high level:
If I had a corporate 401K account that offered limited choices, how would I position?
1. Equities – Single digit growth in the first half of 2017 followed by sheer drop in second half. But timing these things is tricky – see how I cashed out a bit on the early side? If, like me, you believe in capital preservation, maybe start slowly by moving 20%+ of your 401K into the money market funds.
2. Bonds – In the near term there is a lot of risk in bonds. I happen to think that the Fed is just jawboning and rates aren’t moving up anytime soon. Which would mean rates can come downin 2 weeks and bonds will rise. But that’s a risk that I don’t want to take.
Longer term, say 3~6 months, I think we’ll start seeing negative interest rates, which will move up bond prices.
3. Gold – Gold dipped a bit today, and I think that was primarily a combination of re-positioning coupled with a bit of a need for capital. If economic concerns are set to spike, gold is a good place to be. And as an inflation hedge, it will be a good play as negative rates enter the picture.
I have never seen a corporate 401K that offered short ETFs as an option. Otherwise I would be shorting anything tied to emerging markets, Asia and small cap companies. The pain always starts at the margin. Along the way I would expect some moves by EMs to prop up the market, or the occasional bullish move due to a random bit of good news from China. But as a longer term investor, the global economy is slowing.
If my only choices were cash, long equities and long bonds, I would do a sequence. Cash for the rest of the year and then look at bonds in mid or late 4Q.
If I wasn’t limited in choices, I would be long defense (think military) stocks. They are already in a good place with the arms races going on in Asia and in the Middle East. In fact, that $1.7 billion cash we gave Iran will turn out to be a solid investment in the US military industrial complex because Saudi Arabia, Kuwait and other neighbors will race to buy 100x that much in US arms.
KEY POINT: The markets look poised to head lower. There are several catalysts to take it lower. Including declining earnings and sales. There will be more downside ahead, whichever decision the Fed makes in their September meeting regarding a rate hike. I suggest allocating a bigger percentage of your portfolio to cash if you haven’t already. There will be more downside ahead.
Sincerely,
Andrew Zatlin
Editor of Moneyball Economics
P.S. Recently, Bloomberg ranked me a top forecaster of US private payrolls.
These benchmarks matter. The stock market moves on them. The Federal Reserve is making their decisions based on them. And I regularly beat consensus almost every time.
I beat Citi. I beat JPMorgan. I beat Credit Suisse.
On top of that, our Moneyball Trader keeps outperforming the market and every other advisory out there.
Our hit/success rate is north of 70% – meaning more than 70% of our calls have yielded positive returns.
Our cumulative returns are over 70% since inception.
Go to the big boys if you want to pay the big fees. Or you can just check out The Moneyball Trader to get your actionable insight for just $99 (this discounted price is for a limited-time only). Click here for more information.