We Don't Trust This Market - Part 1

Summary

• Part I: Last Week. Worst week since October 2008!
• Part II: This Week. A market that can't be trusted!
• Part III: Game plan. This is no time to be brave!
• This idea was discussed in more depth with members of my private investing community, Macro Trading Factory. Get started today »

Note: This article was first published to both Macro Trading Factory as well as Wheel of Fortune with regard to the Funds Macro Portfolio ("FMP").

Part I: Last Week

Last week was brutal.

Although the market clawed back much of its intraday losses in the last 15 minutes of trading, during the Friday session, it was the worst week for Wall Street since October 2008.

Only 3% of the S&P 500 constituents closed above their 50-day moving average. That's lower than 99% of historical readings, with data going back to December 2001. The only periods with fewer percentages were July 2002, October/November 2008, and December 2018.

The Dow Jones Industrial Average (DIA) declined 13% over the past six trading days. Going back to its start in 1896, this is the 47th largest six-day decline out of 35,538 data points.

To put that in the right context, during the last 75 years, the only periods with a larger six-day decline in the Dow than the recent one were October 1987 (Crash), September 2001 (9/11), and October 2008 (Financial Crisis).

As a reminder, back in December 2018, the Fed was forecasting a Fed Funds Rate of 3.125% (!!!) by the end of 2020. In December 2019 (only a bit over two months ago!), they had lowered that forecast to 1.625% after cutting rates three times over last year. Right now, the market is pricing in a 0.63% Fed Funds Rate by year-end, implying 3-4 more rate cuts.

High credibility, anyone?

Few samples of the past week (negative) performance of the main indices, as well the leading/most noisy names/assets on Wall Street:

• Virgin Galactic (SPCE): -27%
• Tesla (TSLA): -26%
• Apple (AAPL): -13%
• Dow Jones (DIA): -12%
• Oil (USO, OIL): -12%
• S&P 500 (SPY): -11%
• Nasdaq (QQQ): -11%
• Amazon (AMZN): -10%
• Google (GOOGL): -10%
• Microsoft (MSFT): -9%
• Bitcoin (BTC-USD): -9%
• Gold (GLD): -4%

While vast majority of stocks have suffered double-digit losses, there were few assets that made (some of those serious) money last week. For example:

• Yen/Dollar (FXY): +2%
• 20+ Year Treasuries (TLT): +5%

Both the 30-Year (1.65%) and the 10-Year (1.13%) made new all-time closing lows. To put things in perspective, during the worst recession since the Great Depression, yields were much higher when they bottomed on Dec. 18, 2008: 30-year at 2.53% (+88 bps),; 10-year at 2.08% (+95 bps).

• Volatility (VIX, VXX): +135%

This was the largest weekly spike in the history for the VIX (Volatility Index), which started in 1990.

Contrary to the VIX index, the S&P 500 Low Volatility ETF (SPLV) - yes, there's such a thing (inception: 2011), there's something for anything nowadays - was down 11.8% over the past week.

This wasn't only SPLV's worst week ever (by a wide margin), but it was actually down more than the broad S&P 500 ETF's (SPY) 11.2% decline.

Apparently, even being long low volatility isn't a refuge in such a market.

Part II: This Week

The stock swoon is being driven by fear that the coronavirus outbreak will derail the global economy. This rout has left Wall Street with one of the most oversold readings ever.

We have McClellan Oscillator ("NYMO") data, related to market sentiment, going back to 1998. Last week ended with a reading of -136.48, which is the second most oversold level out of 5,471 data points!

By the way, out of the top-five readings, the past week has contributed 2. Here are the most oversold NYMO readings ever:

1. Aug. 8, 2011
2. Feb. 28, 2020 (Last Friday)
3. May 20, 2010
4. Oct. 9, 2008
5. Feb. 27, 2020 (Last Thursday)

Here are the top 20 most oversold NYMO (McClellan Oscillator) readings and S&P 500 forward returns that followed those reading.

To put all of that into one concentrated chart, here's what stocks have done on average following similar oversold extremes based on the past 18 years-plus:

Theoretically, the above charts should be viewed as encouraging signs. The market is technically oversold (no doubt about that) and based on past-similar cases, the red sea supposes to be heading into the green fields, rather to turn into the dead sea...

Nevertheless, as risk-oriented investment managers (shame on us), we have to ask the following question: Does "technically oversold technically" means/equates fundamentally oversold? And unfortunately, we can't say we believe the market, as a whole, is oversold fundamentally, or (in more simple words) cheap/attractive enough to buy the dip.

The forward 12-month P/E ratio for the S&P 500 is 16.7x, which is below the forward 12-month P/E ratio of 18.9x last week (so great improvement over the past week, obviously).

Thing is, we've only now reached the five-year (forward 12-month P/E Ratio) average, and we still need to see the market move down 10% in order to only reach to the 10-year average.

What's more (concerning) is that the forward EPS estimates for the S&P 500 are most likely still way-too optimistic, based on the "this shall pass in no-time" premise.

Believe it or not, but even over the past week, S&P 500 forward EPS estimates have continued to... rise!!! Instead of analysts downgrading stocks and revising the future earnings outlook (make sense, isn't it?), we're still seeing upgrades and bright prospects, as if this is the same upbeat market/economy we've been at three months (or weeks...) ago.

Our claim is, therefore, that not only we would like to see the forward P/E reaching the long-term average of 15x, at the very minimum, but the "E" (in the P/E) seems to be so twisted right now. As such, we must demand an extra margin of safety, i.e. wait patently for an even lower (=more attractive) multiple, to compensate for what clearly looks as way-too optimistic expectations. Wall Street is still living in the past, apparently ignoring the severe-real negative economic effects, under the hope that this is only temporarily. If you buy the market (SPY, QQQ, DIA, IWM) today, you're essentially being confident that 1) things will be back to normal in due course, 2) there's no real, certainly not long-term, negative effect, and (most of all) 3) earnings are even going to improve inside 2020.

Sorry folks, we don't buy that premise, and we believe that these expectations (for earnings to actually grow) have very little (if any) chance to turn real.

As we pointed out earlier today, on the chat room, we - just like everyone else who is net long the market - love to see green, and we would love to sound more upbeat at this point. However, when the S&P 500 futures move from -60 to +70 in a matter of hours (overnight), solely based on the expectation that Central Banks are about to be pouring more money into the system - this is a clear indication (as far as we're concerned) just how unhealthy this stock market currently is.

You don't treat a junkie by giving him more drugs, and you also can't change (a harsh) reality with fantasy (money). At some point, the way you treat a persistent illness/virus isn't by keep giving the patient more Tylenol or Advil.

More liquidity, at the current juncture we're in, isn't going to do much for the economy. It's neither going to push many people to book a cruise, nor bring millions of tourists to China or Italy.

While we belong to the camp that think there's too much COVID19 panic out there, we fail to see how giving the markets larger doses of the same "monetary drug" that brought us here in the first place would be the right treatment/solution for the current economic slowdown.

It's not liquidity that's missing, but a sense of safety, better clarity, higher certainty, and most of all - a greater belief that the healthcare system (and the world's leaders) can deal with this, swiftly. I mean, you hear/read/look at how poorly border control and/or hospitals are prepared to this outbreak - over two months after it broke up - and it's really hard, likely impossible, to have that sort of belief and confidence.

Having said that, we wish to re-emphasize again (for the 100th time probably) that - based on the available data as of today - the panic is unjustified! Although this is an unpleasant situation, to say the least, and as much as every human life that is being lost (victim to this virus) is a tragedy, this is not a world catastrophe, and I dare saying not even a "grey swan."

Sure, nobody was (or could be) expecting this, so it's popular (and making headlines) to use this as an appearances of a "swan," regardless of the color you attribute to it. We, however, look at the coronavirus (from a financial perspective) as a very good excuse that the market was desperately in need for. You may claim that the market received more than it wished for, and you can also say that this is a very good excuse (no doubt about that), but it doesn't change the fact that it's still, in essence, an excuse.

Part III: Game Plan

First of all, we wish to thank @msubash26 for asking us two (back-to-back) questions that were spot on, as they exactly reflect the main topic we have/had in mind to touch upon at the start of this week.

Below, we bring both questions as is (bold font), followed by our (original) answers, but in an elaborated version, that includes more words, graphs and charts.

Q1: Any changes expected in the FMP after the horrific week? and what's the prospect for next few weeks expected?

Certainly! We will communicate those over the course of the coming week (as early as today).

Truth is, the FMP had a very good month until last Friday, outperforming the SPY on both absolute (by as much as 1%) and relative (risk-adjusted) returns. That came after a couple of weeks (second half of January into the first week February) where the FMP was behind on absolute terms, but in-line and even slightly ahead on relative terms.

The entire past week, but mostly Friday, was very weird for the FMP, mainly due to precious metals crashing along stocks, and certainly not providing the natural hedge one would expect these assets to deliver at such times.

Had we ask anyone a week or two ago what would they like to hold ahead of a week like last week - gold (specifically) and precious metals would be a certain top-3 pick/s.

I mean, holding precious metals ahead of a such week...

• Main indices falling >10%;
• Expectation for the Fed to go from flat/-25bps to -75/-100 bps;
• 10-year yield down to 1.13%;
• Coronavirus and (general/health) panic spread all over the globe;

… would have been on everyone's list, and rightly so!

We thought that we're actually being positioned very favorably for such a week:

1. Reducing exposure to tech (XLK)? Check (positive)
2. Reducing exposure to energy (XLE)? Check! (positive)
3. Increasing exposure to healthcare (XLV)? Check! (positive) - by the way, somewhat contrary to common sense, that was especially true for smaller-caps healthcare (IBB, XBI) that have outperformed the market big time.
4. Holding 9% in cash (IGSB)? Check! (positive)

Even the defensive sectors that we have very little exposure to (since the beginning of the year) - utilities (XLU), real estate (XLRE), consumer staples (XLP) - have collapsed last week, making our positioning even more well adjusted for such a week.

So basically, everything looked fine, set and ready for the FMP to outperform.

What went wrong? The only thing that hasn't worked out, as planned, was the thing that should have been the easiest of them all - precious metals. More precisely, those were the specific instruments we're using (gold and silver miners) than the commodities themselves. While gold and silver lost ground, falling 2%-3% since the market peak on Feb. 19, the gold (GDXJ) and silver (SIL) miners ETFs have lost 17%-18% over that period.

Since 2/19 and until 2/23, precious metals actually functioned just as one would expect them to - a perfect hedge against the a market drop. Starting 2/24, particularly over last 3 trading days (2/26-28), precious metals have performed just as bad, and in the case of miners - much worse, than the market. That's a real shame, because if you think about it - there's really no reason whatsoever companies to fall 6-7 times as much as the prices of their underlying goods/commodities.

It's very frustrating to position yourself (in advance), in what would be described/seen as a perfect way (even retrospectively), just to find out that what was/is supposed to be a perfect hedge, almost a dream comes true, at such a troubled time, is performing so badly.

FMP is still performing in-line with the SPY, but Friday took us back on a risk-adjusted basis. We will make changes this week in order to ensure that we're better positioned to deal with the current situation, so stay tuned.

Q2: Does toe current scenario provide buy-in-dips opportunity or are we in another few weeks of tumultuous journey?

This is a very good question that we actually addressed on Wheel of Fortune over the last few days. Our general take is as follows:

1. On a global/macro/market level: We still think that this is an overvalued market and we don't buy the dip.

2. On a sector level: We prefer the defensive/non-cyclical (telecom, healthcare*, real estate, utilities, consumer staples, precious metals*) over the aggressive/cyclical ones (tech, energy, consumer discretionary, financials, materials* ex. precious metals, industrials*).

(*more on the border than the others)

3. On a single-stock (specific names) level: A lot, if not most (!!!), of the stocks are now fairly- and undervalued. On Friday, at some point, more than one-third of the S&P 500 constitutes already lost at least 20% since their peak!

Naturally, the broader, i.e. moving from large to smaller caps, you go/look at - the higher the ratio of stocks already trading in "bear territory" is.

This means that we find ourselves in an awkward situation: On one hand, we can point out at many single names/stocks that we like right now. On the other hand, we don't trust this market, and we still don't buy the dip (as a whole).

This is exactly the reason why we didn't do changes to the FMP since Feb. 4. We positioned ourselves more defensively (which turned out to be wise, albeit the precious metals "malfunction") and now, even after the market tanking 16% (at the bottom of Friday), we don't think that this is the right time to buy the market, be it SPY, QQQ, DIA, IWM, or any other broad-market index/ETF for that matter. Not at all!

So we are indeed taking the time to give this a very deep thinking, as there are (always) pros and cons to every action, but these days the result might be extreme, so any action must have a higher-than-normal conviction, and more importantly - the ability (in theory for sure) to deal with various very volatile/distressed market conditions.

Decisions and actions (for the FMP) must not be taken too quickly or lightly. It's way easier (for us) to point at single stocks and say "This is a great buy right now" than doing the same when it comes to the overall market.

What is the best way (if there's any) to tackle this conundrum and how do we intend to position the FMP going forward? The obvious outcome is to be less aggressive and (even) more defensive (than we already are), but we're considering other, less conventional, actions, that may include (but aren't excluded to) any of the following:

• Naked shorting (for the first time this year)
• Pair-trading (long and short, together)
• Leveraged ETFs
• Inverse ETFs (which is less likely)

We certainly don't want to rush (too early) into the wrong action, so we wish to see how this week starts and gets unfold before taking actions. Nonetheless, we don't intend to let the FMP goes without a change for over a month, so you're going to hear from us.

Analyst’s Disclosure: I am/we are long AMZN & SHORT AAPL (PAIR TRADE), GLD, IGSB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

AAPL positioning:https://seekingalpha.com/article/4315894-apple-is-sell-300-pure-and-simple-will-diagonally-after-all TSLA positioning: https://seekingalpha.com/article/4315501-tesla-451-share-post-2019-delivery-numbers-is-soft-sell