The Magnificent Many
In the past few trading days the stock market has broadened spectacularly. The Nasdaq 100 and Mag 7 have been left in the dust by the Dow 30 and Russell 2000, the former having soared 742.76 points to notch a fresh all time high today and the latter having packed on 11.5% just since this time last week. Even having foreseen this broadening, I’m surprised at its vigor, and certainly wasn’t expecting such immediate gratification.
But if you’re anything like me, you’re quickly bored by such statistics about the past, even the very recent past. The more interesting part is what happens next. Of course that’s the part we don’t know.
I’d like to tell you that this is the beginning of a new trend. That if you get on board right now, you can make another 11.5% in the next seven days. Alas Mr Market doesn’t work that way; if it did we could all get rich quick just by betting on recent history to repeat. Not to mention sustainable trends just don’t look and feel like this.
This has all the hallmarks of a crash … a sudden violent move that corrects a divergence that has gone too far. Like an earthquake relieves stresses in a brief interval that have built up over time. If we want to benefit from moves like this, we have to spot the divergences before they crack.
I don’t know if this has yet been enough to restore the dynamic equilibrium that normally characterizes markets. It hasn’t erased the gap between “growth” and “value” that so many analysts have written of, but that could take years. In any case, this quake may have even gone a bit too far too fast. There may be aftershocks, but there may be reversals too. Generally this breathtaking stock rally is living on borrowed time and prices are likely to move bidirectionally if not outright downwardly in the coming weeks.
A word on gold. Back on April 3, when it was trading around $2200, I had estimated it would soon reach $2400 but have difficulty breaking higher. It did exactly that, and then back and fill for a while, but now has decisively broken through that $2400 glass ceiling. This breakout is likely good for another couple hundred dollars … the path is open to $2600.
But apparently not yet! Gold is down sharply (yet still hovering over the $2400 mark). Cue Meta “gold getting killed”…
It’s not really about gold though. This is a classic dollar up day. Dollars are up against foreign currencies, copper, gold, oil (indeed the broad S&P GSCI commodity index), US Treasuries, US stocks, XS stocks … and as readers are aware, in Finsterian economics, whenever everything looks like it’s going in the same direction, check your units.
You could call it a mini deflationary squall. In that sense, it’s good economic news, at least for ordinary Americans struggling with inflation. As it works its way through the pricing chain, lower consumer prices follow. If it continues, it will finally justify the much ballyhooed Fed rate cuts.
Investors want to know, though … how best to be positioned? Depends on how much more we see in coming weeks, and I don’t know. FWIW I’m overweight USD (cash), UST (bonds), and gold in my discretionary accounts. But smarter people might know better…
Gold’s retreat back below its $2400 ceiling means the $2600 target will be deferred. Unless inflation (dollar depreciation) is somehow permanently vanquished though, it remains virtually inevitable … the real question isn’t if but when.
This puts us squarely back in odds making mode. On the totality of evidence available at this point, it’s more likely to be reached in the next 6-12 months than not. Just to cite one of the bigger pieces of evidence, the bond market has begun to cut rates and it is likely the Fed will follow. This is a tailwind for gold prices. Another is that none of the contenders for this fall’s US elections are running on anything remotely resembling a fiscal prudence or anti-inflation platform.
It could continue to be a volatile ride, but the secular trend for dollar-denominated gold prices remains higher. Technical indicators though favor more consolidation in the $2400 area for the time being.
the mag 7 is over 30% of the s&p index, and a huge portion of retirement savings resides in target funds with big s&p exposure or in s&p etf’s directly. if the mag7 goes down enough, dragging the index along for the ride, there is potentially a tipping point at which boomers dial 1-800-get-me-out. in such a scenario small and value might outperform on a relative basis, but still drop as the index funds unload.
another crash scenario involves the unwind of the dispersion trade. briefly, volatility of individual stocks is greater than volatility of the index which they constitute. many billions of dollars run by “pod shops” at the giant shadow banks and hedge funds are invested in arbitraging this difference. they buy the vol on the mag 7 while selling the vol on the index. if mag7 vol explodes they lose money on the long side of their trade. meanwhile index vol will not increase enough to offset this loss to the extent that the s&p 493 doesn’t sell off as much as the mag7. if the pod shops sell their vol spread to get out of this trade, mag7 vol goes up while index vol goes down, amplifying the move and the difference in performance between these market moieties. but again, i think the s&p493 would still go down, just not as much.
btw, a partial dispersion trade unwind may fully explain the outperformance of small value during the mag7 selloff. i.e. the outperformance of smallvalue very recently may be purely technical.
CORRECTON: if they buy mag7 vol then an increase in mag7 vol is a gain, not a loss. to analyze this we’ve got to get into how they implement the trade, i assume via selling option straddles. if mag7 drops they have to “delta hedge” their short put position by selling underlying assets- most likely s&p or nasdaq futures. this would exacerbate the selloff of the indices. being cap weighted, selling the indices causes disproportionate sales in the biggest caps, exacerbating the selloff in those equities in particular.
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frankly, this dispersion and options stuff is a stretch for me to understand.
“… in such a scenario small and value might outperform on a relative basis, but still drop as the index funds unload …”
Exactly. I might have said it myself but for the Finsterian epistemology that everything is relative…
… eg a marketwide decline in dollar terms, especially if it extends across geographies and asset classes, is also a rise in the value of the dollar. While it may prompt much wailing and gnashing of teeth on Wall Street (and among said boomers), it would be a disinflationary event and actually could justify the Fed rate cuts it has been agitating for.
FWIW I think the options gamma stuff is overrated, aside from the very short term. If traders take an effective short position, the dealers swing effectively long, and vice versa. On the scale of hours imbalances can drive or mute big moves, but as you approach a weekly time scale it appears to pretty much come out a wash.
This immediate gratification thing is turning into a broken record. Already the Russell 2000 has reversed some of its “too far too fast” gains, selling off over 100 bp today. The Dow has so far managed to stay in the green though, while the Nasdaq continues to take a well-deserved beating.
The broader global stock market has already begun to display the anticipated bidirectional-to-downward behavior, also down in excess of 100 bp. Now this trend looks sustainable, at least for the seasonally appropriate next 12-16 weeks, given how overextended the rally grew.
Although Financology generally steers clear of politics, the recent high political drama – with one presidential candidate appearing near incapacitated and the other literally coming within an inch of his life in an assassination attempt – merit some comment.
The sheer drama makes it tempting to read perhaps bigger economic portents into the US election than may be warranted. I’m much more a policy guy than a personality guy, and despite some clear contrasts in other areas, it’s not at all clear that either candidate can lay claim as an inflation fighter. The recent bout with consumer price inflation was caused by excessive federal deficit spending underwritten by easy monetary policy. The Fed’s efforts to counter it while the fiscal disaster was ongoing merely transferred the costs to ordinary Americans, who have had to tighten their belts because the government wouldn’t. The blame lies squarely with the Biden administration and its congressional support, but early indications are a Trump administration would do nothing to change it. More spending and easy money appear on the horizon either way. Trump risks a US version of the UK Truss debacle.
History may not repeat, but it alliterates.
PS This isn’t an anti-Trump rant; I support many of his policy priorities. This is strictly about the outlook for debt and inflation.
A contrary opinion: Greg Guenthner writes on The Daily Reckoning that the small cap rally is just getting started:
https://dailyreckoning.com/the-rotation-is-real/
I’m still skeptical, particularly about the near term, but Guenthner makes a case worth considering. On the other hand, our outlooks may not conflict as much as they first appear; we agree on the broader question of broadening … while I don’t see small caps continuing to rack up big gains, I don’t see the market going back to being moved by just a handful of supercaps either. What we’ve just seen is mostly just a re-equilibration event moving an out-of-whack relationship back into whack.
More on this from Lance Roberts at RIA:
Can Mega-Capitalization Stocks Continue Their Dominance?
From a fundamental and valuation perspective, the longer term prospects for the Russell 2000 aren’t especially compelling either. Taking into account the listings with negative earnings (not uniformly done) recent aggregate PEs have been running in the upper twenties, CAPE ratios even higher:
https://siblisresearch.com/data/russell-2000-pe-yield/
This article by Jeffrey Kleintop at Schwab was an eye opener for me. Much geographical stock market performance variation turns out to be a sector variation:
How Much “Tech” Do You Own?
Is the Mag 7 bubble imploding? That might be a bit premature, but NVDA is down over 7% in today’s trading and further selling off in after hours. META is down over 3% after a weak session. Even bulletproof MSFT is down over 6% after hours. These businesses aren’t collapsing, it’s just that only surreal results could justify what was priced in.
This is on top of general supercap underperformance over several trading sessions, with the heretofore-lagging Dow 30 and Russell 2000 stoutly outperforming. Our dividend-quality-value-oriented Income Portfolio is up nicely during this period of (cap-weighted) market weakness … ironically where we care least about price performance.
And indeed the late great small cap rally, mere days ago crowned by Wall Street media as stock market savior, is dead. Long live the king!
Yesterday small caps were taken out and shot. Then today the corpse was dragged back up, propped against the wall, and shot again.
Today R2K fared even worse than R1K, down -3.54% (versus -1.95%). For the first two days of August, -6.67%. Financology readers were fortunate not to jumped aboard that train before it headed over the cliff.
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