It seems like the world has changed quite a bit in the last 3 weeks. The S&P500 is up over 10% from the intraday low on the 9th of August, and we're hearing many voices calling for a benign economic outcome - the worst may have been avoided. Really?
In a post on the 9th of August ("After the Market Rout: Time to Cut Shorts"), I argued that market pricing had to a large extent caught up with poor economic data, and that it was time to cut shorts and that an interim bottom was in. Well, I'm happy to say that the 9th August did mark an interim market bottom and we're up 10% since.
As the month of August has ended, there is a bullish smell in the air, with many abandoning the the bearish trades. It's true, we had three positive surprises on the data front (Milwaukee, Chicago PMI, and then the ISM), and more importantly, the month-end rebalancing flows have been positive for stocks (ie, Asset Allocation mandates with constant targets have sold bonds and bought stocks on the 31st of August).
However, the loss of growth momentum has been considerable in recent months and a recession is a possibility. The last print for YoY Nominal GDP growth was 3.7% (Q2), while the last print for YoY CPI was 3.6% (July). It looks to me like there is really little real growth left. At the same time, commodities (and oil in particular) haven't fallen enough to alleviate the consumer squeeze or allow central banks to ease aggressively. The near-term won't be easy.
In all the gloom, I have to recognize two positives, which will potentially play a role a little later. First, valuations are starting to become attractive again (see MSCI Asia ex-Japan P/B in blue and BV/share in red below). Second, companies are generally in rude financial health and have capacity to buyback shares, which they have already started, or undertake other shareholder-friendly actions.
However, for the next 3-6 months, the direction of the economy and earnings revisions will be key, and for now the trend is down. ISM is possibly the single best indicator of the cycle, and although the headline came at a better-than expected 50.6, there are reasons to be worried about lower readings in the months ahead. New Orders-Inventories and the the Philly/Empire combo are signaling lower readings to come.
The market is discounting some slowdown. The current level of the S&P discounts a trough of around 48 on the headline ISM. I'm afraid that's not a lot of margin for error, and an overshoot is likely.
Click to enlarge
Given the above, I would argue that now is the time to put on some bearish trades - at the very least as protection for core long positions, or purely directionally. Alternatively, if you judge volatility too expensive, you can sell out-of-the-money calls on the main stocks indexes - a kind of covered-call strategy if you're already long. Lastly, if we get another leg down in risk, I believe that the USD will finally rally. If we don't, then the downside appears limited against the majors (not talking about gold here), so go long the DXY.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.