Investors fixated on the index level of the S&P 500 may be forgiven for getting bored with markets as it has been stuck in a 150-point range over the past six weeks. What is happening underneath the hood is a lot more fascinating, especially because of how fund managers and institutions are positioned. It has been no mystery that the only sector investors have positioned in has been the Technology sector (growth) vs. short Energy, Mining, Industrials, Financials (cyclicals). This was the case going into the start of the year as the top six names dragged the S&P 500 to new highs, also making up about 22% of the market cap. As the market sold off aggressively in March, the first sector to rally was also Technology given their earrings resilience, solid balance sheets and aggressive buybacks. What changed the last week?
The Financials (XLF) , Energy (XLE) , Mining, and Industrials are all rallying at the cost of Technology over the past week - the classic cyclical rotation. This is typically synonymous with an improvement in the economic data indicating a rebound. Other than the economies reopening, which have been more than reflected in the market which is now trading on 24x PE on 2020, the economic data has been muted. The data ranging from PMI, ISM, orders, etc. have only shown signs of stabilization, but certainly no signs of a V-shaped recovery. There is a lot of hope vs. actual facts being priced in currently. Perhaps investors are tired of being overweight the Technology sector which is back at year highs, and they need to buy something as they suffer from FOMO. At market tops, investors usually face this desperation to chase the laggards of the year with the hope of making up some performance.
We have 40 million Americans unemployed, large corporations raising close to $1 trillion but just hoarding the cash expecting harsher times ahead, and banks holding onto reserves. There are no signs of capex increasing nor consumer spending to pick up. These jobs are not coming back anytime soon. This is the retaliation that most need to have. Perhaps following Q2'20 earnings, it will be much clearer to investors that the recovery is indeed U-shaped or even L-shaped, but far from V-shaped.
There is another factor that could have contributed or rather exacerbated this trend. The DXY Index. For the past three months since the market recovery, the U.S. dollar has been holding in a tight range. Given the unprecedented amount of Fed quantitative easing and buying up of assets, it is logical for the dollar to fall over that time. But every central bank is also printing copious amounts of money and cutting interest rates to stimulate their economy out of recession. It is a global race to the bottom as Fiat currency, as we know it, is getting debased every day. The U.S. dollar is still the lesser of the evils given the slowdown witnessed everywhere. It is the safe haven currency. In addition, global debt is in dollars and as the slowdown gets worse, economies need to find more dollars to service their debts - the classic global dollar shortage. The Fed knows this as they are the buyer and lender of last resort these days. A higher U.S. dollar is not good for the global economy, but then it does not help to "Make America Great Again" either. More importantly over the last week, the technical pattern of the DXY index broke down, which caused it to aggressively fall to the $97 level. Could this move have triggered the algorithms/momentum traders to close their dollar longs, causing an even bigger move down in the dollar?
A lower dollar implies a risk-on tape, which pushes up cyclicals and Commodities like copper, energy, etc. This technical breakdown could have started a self-fulfilling prophecy, generating the cyclical rotation that we are witnessing today. Combine that with everyone short of these sectors, now rushing to unwind them. We have rallied on the hopes of reopening, but analyzing the data from China, Europe, and the U.S. shows no evidence of a sharp rebound.
It is important to keep an eye on the dollar as it underlines the performance of all asset classes and sector rotation. Whether this is a knee jerk reaction, false break to the downside, or a secular move lower, that remains to be seen. But it is important to understand when the fundamentals and earnings do not back a cyclical recovery that this is nothing other than a portfolio unwind, rather than the start of a new trend.