August has always been labeled a "quiet" month -- quiet in terms of volume and liquidity, certainly not in terms of news flow and volatility.
Fund managers are often warned by their risk departments to take their portfolios down going into August as most "logical" and "rational" investors are out of the market and off to the beach.
Last week the S&P 500 fell 8% in a few days down to 2777, to then rally 5% going into the weekend. Boring? Dare I say, not!
More than half of the world's global bond market is trading below the Fed funds rate, with more than $30 trillion worth trading at negative yields, and we call this an "investable" market? There is no doubt the Fed is losing control of its central bank policy and being bullied by a president who throws even more curve balls once the Fed manages to steer the ship in the right direction. With more tariffs imposed on China starting Sept. 1, and no end in sight to either side giving in, and global economic data worsening, why then did the S&P 500 bounce so aggressively off its 200-day moving average of 2777 and now firmly holding onto the key 2900 level?
As Trump proposed more tariffs on China, China retaliated by letting its yuan weaken to the dollar past the "7" mark -- devaluation! This has angered Trump even more as the lower China's currency falls, the cheaper its exports become, allowing the nation to "win" the trade war against the US.
Every central bank in the world is now cutting rates, allowing currencies to weaken. The U.S. is rightfully late, given its gross domestic product growth is still in the 1.8%-2% range. The problem with this school of thought is that the People's Bank of China uses its daily fix of the yuan to prevent capital outflows, while at the same time preventing depletion of its foreign exchange reserves. A delicate balancing act, but one that China is determined to use as Trump decides to play tough; China will not acquiesce to the U.S., nor Trump's will. Trump likely knows that, and is just articulating this to scare the Fed into cutting rates as close to 0 to re-lever the system going into election year 2020. This was never about winning a trade war, it was always about squeezing the system to inflate asset prices even further.
Going into August, the market was extremely long on the market -- the SPDR S&P 500 exchange-traded fund (SPY) -- and short volatility through the Volatility Index (VIX.X) . These two have an inverse relationship, whereby as the market grinds higher, volatility goes further down. After years of buying protection, which has been a losing strategy for most hedge funds, the trade has now been short volatility or short gamma. It's a very lucrative strategy, if one is in stable, one direction markets, but a very painful one if there is the slightest bit of volatility. As news of Fed hawkishness and new China tariffs rocked the market the other week, volatility exploded causing the S&P 500 to fall dramatically. The same thing happened last year in February as the VIX blew up, as investors thought volatility could only go down, but never up.
Above 2950, the dealers have been short gamma. What this means as the market breaks 2950 to the downside, they become extremely long on the market -- so to hedge their positions and risk accordingly, they need to sell futures as the market falls below their level. It's counter-intuitive, but such is the world of negative gamma trading. Once investors realize where the "pain" is in the market, they would be wise to take the other side of the trade. In this case, buy the break below 2900 and sell the move above, in turn profiting from the "technical" set up of the market.
This market is driven and supported by company buybacks and commodity trading adviser momentum driven trading strategies. We have exited the second-quarter earnings period with most companies faring better, but still reporting earnings decline year-over-year. After their reports, as usual, the larger U.S. technology companies have ramped up their buybacks with their huge piles of cash supporting stocks, as they fell down to their 200-day moving averages.
Apple (AAPL) is a good example that held onto its $190 level to rally back above $200. The market has been signalling an inflection point for some time, judging to the aggressive 15%-20% sell-offs and rallies over the past year.
This is crucial for commodity trading adviser-driven funds, as -- if they sense the trend has changed -- they can and will move from outright longs to outright shorts. According to a note by Charlie Elligott from Nomura, CTA's sell level is a break below the 2830 level. Currently they have trimmed their long exposure from 100% long, down to about 66% long. If this trend is broken, the same flurry of money that chased market higher, will be chasing it lower. This will be lost on the average investor who has never seen or known anything other than "buy the dip" over the past decade.
Front month volatility expires this Friday. If we hold around this level, 2900, those options expire worthless. These same dealers will need to then sell more volatility to balance their books causing the same compression in volatility that we saw earlier, leading markets to rally or at least hold these levels for now. This can be supportive for equities, especially the S&P 500, for the very near term.
Fundamentally, there is no doubt that equities, bonds, and most asset classes are at risk of breaking down, especially in a world where Global purchasing managers' indexes are contracting and there are signs of serious stress in the system. China is in pain, but it's willing to hold out until next year, rather than give into Trump today.
China is short dollars, given its financing needs, and the dollar continues to strengthen as the least of the evils. Commodities like copper and iron-ore, which are linked to China's demand, will continue to weaken until there is a pick-up in growth. Even semi-conductor export growth showed a decline of 22% year-over-year for the first ten days in August; the slowdown is real.
Keeping the bigger picture in mind, it is important to know what is brewing in the market and why it is taking its merry time to show its true colors. It may take some time, but the path is clear as risk is to the downside. The Fed will need to see more market downside to cut 100 basis points and global economic data will not improve until Trump calls off his tariffs with China. Gold is trending higher and the yuan is at risk of falling down even further if things do not change.
Investors never like to hear this, but sometimes it is best to sit this one out than get sucked in for the wrong reasons, especially if one cannot explain why it is going up or down in the first place.
Cash truly is king.