Cycle Capital Macro Weekly Report (8.12): Roller Coaster Market

The most volatile week in 2019

Although the US stock market remained basically flat over the week, the market was a true roller coaster.

On Monday, panic dumping, retaliatory Rebound on Tuesday, technical selling on Wednesday caused the market to plummet again, while the first-time jobless claims, which usually have a limited impact, triggered the impulse to catch the bottom in the market on Thursday, although this data is not worth excessive excitement, as the trend of continuously increasing continuing jobless claims is obvious. The market continued the Rebound trend on Friday, but the magnitude slowed down.

Over the past week, the stock market has been closely linked to the encryption market. In the media, the recession in the United States and the unraveling of the Arbitrage trade with the Japanese Yen are two core themes. However, I believe these are two ‘false propositions’. In fact, the real panic was also very short-lived, and the usual crisis of dumping everything, including bonds and gold, did not occur.

After the dumping in the US stock market on Monday, there was a Fluctuation of about 4.5%, the largest Fluctuation since the 2019 coronavirus panic. Fluctuation means risk, but it also means opportunity. I quickly recorded a video during Monday’s trading session, explaining why dumping, except for the yen, is excessive panic. This is a golden opportunity for mainstream encryption and the stock market, and a short-term high point for bonds. In summary, the main points are:

• Most of the current US economic data is good, and the trend is also positive, with only a few data supporting a recession, and these data types have been proven to be less reliable in this round of recovery.
• Enterprise profit rise situation is good, just the magnitude of exceeding expectations has not expanded.
• Secondly, it is impossible for Japan to continue raising interest rates because the enormous debt cannot be absorbed by the economic rise.

• The short-term panic triggered by the unexpected interest rate hike has led to the unwinding of the previously high-leveraged positions. It is speculated that such a stampede will be digested by Monday based on the data.
• The trend of fixed income and USD forex market dominated by big players does not match the conditions of panic trading or liquidity scarcity.

So it can be concluded that the possibility of accidental manslaughter on Monday is higher.

However, it is necessary to further observe the changes in the data, and it can now be said that everything is fine, and it is still too early to return to the way it was before, after all, from the perspective of capital preferences, the aggressive defense has not changed so far, and the disappointment with Big Tech has escalated a bit to the level of “killing narrative” (killing performance, killing valuation, killing narrative three stages of decline, becoming more and more serious), unless NV’s financial report can once again smash all doubtful voices to mobilize industry sentiment, so US 30 and US in the next few months 500 may be better than US 100. However, at the trading level, Cyclical has lagged behind defensive a bit more recently, and the possibility of a larger short-term rebound cannot be ruled out.

Goldman Sachs clients bought tech stocks at the bottom last week, with the volume hitting the highest in 5 months:

On the other hand, as bond prices pump, the interest rate falls, providing a buffer for the stock market fall. In the past month, the US 10-year yield has dropped from 4.5% to 3.7%, a significant 80 bp change that far exceeds the expected decrease due to interest rate cuts. Unless a recession is truly imminent, such pricing clearly presents an opportunity, similar to the market situation when enthusiasm for interest rate cuts was high in the fourth quarter of last year (5% fall to 3.8%). Personally, it seems that the market in recent years is more animalistic than before, and pricing is no longer as rational.

The recent pullback in the stock market started from a historical high, with a maximum decline of 8%. The current level is still 12% higher than the beginning of the year. Due to the pump in bonds, diversified investors are not only affected by the overall decline in stock indices. Therefore, the situation of chain dumping is not a major concern in the U.S. stock market. On average, we experience about 3 adjustments of over 5% and one adjustment of 10% or more each year in the past few decades.

The decline and adjustment of the stock market, if not accompanied by economic or corporate profit decline, are often temporary, followed by a good upward trend.

However, considering that the pessimistic sentiment in technology narrative is unlikely to quickly reverse, and the short-term and severe fluctuations have caused significant damage to many investment portfolios, there is still a need for mid- to long-term funds to adjust their positions. The short-term fluctuations may not have completely ended, but it is unlikely that the market will start a larger and deeper decline. The strong rebound in the second half of last week is a positive signal.

According to JPM’s statistics, from the relative historical adjustments of various assets, due to the larger fall in metals, the larger rise in government bonds, and the smaller fall in stocks, the recession expectations reflected in government bonds and commodity markets are even greater than those in the stock market and corporate bond market.

91% of the companies in the S&P 500 have released their Q2 financial reports, and 55% of them have exceeded revenue expectations. Although this proportion is lower than the average level of the past four quarters, it is still higher than 50%, indicating that the performance of most companies in terms of revenue is still acceptable.

From the chart, it can be seen that there are significant differences in the performance of various industries. For example, the health care, industrials, and information technology sectors have performed well, with a higher proportion of companies exceeding expectations, while the energy and real estate sectors have relatively poor performance.

NVIDIA’s valuation has already pulled back:

Its 24-month forward PE is currently 25 times, close to the lowest point in the past 5 years (about 20 times), endorsing a PE premium of 1.8 times to 1.4 times for SPX, indicating that NVIDIA’s valuation is gradually becoming more reasonable.

The financial reports of large technology companies this quarter are solid, and there is actually no situation of killing performance. The main reason for killing valuation is the increase in AI investment:

Palantir raised guidance, emphasizing AI boosting performance, stock price surged 37%, sparking some AI narrative discussions on the street.

About the Expectation of Interest Rate Cut in September

JPM research calculates that the Fed’s federal funds Intrerest Rate target under the Taylor Rule should be around 4%, 150 basis points lower than the current Intrerest Rate. The Fed has reason to quickly adjust its policy to better reflect the current economic situation.

In terms of market pricing, the September FOMC meeting is expected to lower interest rates by 25 basis points, but market expectations may exceed 25 basis points. During Monday’s trading, due to panic, it was priced at 63 bp at one point, and finally closed at 38 bp this week. In addition, the current market has already digested the expectation of the Fed cutting interest rates by 100 basis points this year, which is equivalent to four times.

The data that first exceeds 25 bp and exceeds 3 times in a year is expected to deteriorate continuously, especially the data on the employment market to support, otherwise this pricing may be excessive. If the data supports, the market will gradually price in the possibility of a 50 bp rate cut in September or even a 125 bp rate cut in the year.

From a trading strategy perspective, in the short term, the US Interest Rate market has mainly been in a pullback mode when it rises within 2 weeks. For a period of more than 1 month, it is in a bet on the decline mode because the interest rate cut cycle is bound to begin. Whether the rise in the unemployment rate indicates an economic slowdown and potential recession still needs time to improve the consensus, during this period, there will be continuous fluctuations in emotions.

The speech of the central bank officials last week was slightly dovish, but overall it was noncommittal, which was expected.

Encryption Market

Experiencing the most dramatic pullback since the FTX crisis, the price of BTC has rebounded after dropping more than 15%. This pullback was triggered not by internal events in the Cryptocurrency market, but by external shocks from the adjustment of traditional markets. The technical aspect is also severely oversold, almost to the same extent as last year’s 816, when BTC experienced a plummet from 2w9 to 2w4, followed by two months of consolidation.

So it can be understood why encryption Rebound is so intense.

The following analysis is quoted from JPM’s research on August 7th:

Retail investors also played an important role in this adjustment. BTC Spot ETF saw a significant increase in fund outflows in August, reaching the highest monthly outflow since the establishment of these ETFs.

In contrast, risk aversion among players in the US futures market is limited. This can be seen from the changes in Holdings of CME BTC futures contracts, and the forwardation of the futures curve indicates that futures investors still maintain a certain degree of optimism.

BTC dropped to around $49,000 last week. This price level is comparable to the estimated production cost of BTC by JPMorgan. If the BTC price remains at this level or below for a long time, it will put pressure on miners, which may further exert downward pressure on the BTC price.

Several factors may keep institutional investors optimistic:

• Morgan Stanley recently allowed its wealth advisors to recommend BTCSpot ETF to clients.
• The liquidation pressure of Cryptocurrency payments from the Mt. Gox and Genesis bankruptcy cases may have passed.
• The payment of over 10 billion US dollars in cash after the bankruptcy of FTX may further stimulate the demand for the encryption market at the end of the year.
• Both sides of the US election may support regulations favorable to Cryptocurrency.

Funds and Position

Despite the significant reduction in stock allocation due to the recent decline in stock prices and a sharp increase in bond allocation over the past few weeks, the current stock allocation ratio (46.5%) is still significantly higher than the average level after 2015. According to J.P. Morgan’s calculation, if stock allocation is to return to the average level after 2015, stock prices need to fall further by 8% from the current level.

Currently, investors have a very low cash allocation, indicating that more of their funds are concentrated in stocks and bonds. A low cash allocation may increase market vulnerability when facing pressure, as investors may need to sell assets to obtain cash during market downturns, potentially exacerbating market Fluctuation.

Recently, there has been a significant increase in bond allocation, as investors turn to bonds as a safe haven asset during the stock market pullback period:

In the recent market Fluctuation, the reaction of retail investors has been relatively mild, and there has been no large-scale withdrawal of funds:

Retail investor sentiment survey remains positive:

The change in position of Nikkei futures indicates that speculative investors have significantly unwound their long positions.

As of last Tuesday, the speculative net short position in the yen (blue line in the figure below) has basically returned to zero:

How big is the scale of ‘Japanese Yen Arbitrage Trading’?

The Japanese Yen Arbitrage trading mainly consists of three parts:

• The first part is foreign investors buying Japanese stocks. For safety reasons, they will create Derivatives worth the same scale as the yen for short selling. Recently, due to the decline in Japanese stocks, the yen pumped, so these investors incurred losses on both sides and had to close the entire position. The amount of investment by foreigners in Japanese stocks estimated by the Japanese government’s statistics is about 600 billion US dollars.

• The second part is foreign investors borrowing Japanese yen to buy assets abroad, such as stocks and bonds. It is calculated based on the total amount of yen credit to non-bank borrowers outside Japan, according to the Bank for International Settlements. This operation amounted to approximately $420 billion at the end of the first quarter of 2014. However, the relevant data is only updated quarterly, and second-quarter data is not currently available.

• The third part refers to domestic investors in Japan who use yen to buy foreign stocks and bonds. For example, Japan’s pension funds use yen to buy foreign stocks and bonds to pay future pensions. Before adjustments, such transactions amounted to about 3.5 trillion US dollars, of which about 60% were foreign stocks.

If we add these three parts together, the total volume of the yen Arbitrage trading is estimated to be about 4 trillion US dollars. If the future Inflation situation in Japan forces the Central Bank of Japan to raise Intrerest Rate, then this kind of trading will gradually decrease. So this is why short positions are unwound in the short term but long positions may still have an impact.

In summary, different types of investors are adjusting their investment strategies according to market changes:

• Trend-following or speculative investors (such as CTAs): Recently, they have had to sell a large number of long positions in stocks they previously held and shorts in Japanese yen.
• Yen Arbitrage trading: If the yen appreciates, this operation will lose money. Although the yen’s trading has changed from Oversold to Overbought, overall, this $40 trillion mega trade has not been significantly unwound.
• Risk parity funds: Recently, the market has experienced significant fluctuation, and they have also reduced their investments, but to a lesser extent than CTAs. However, the pump in bond prices has helped them control losses.
• Ordinary retail investor: Compared with previous stock market declines, their withdrawals are not many this time.

Chinese thematic funds have attracted a net inflow of 3.1 billion US dollars since the end of May, with passive funds continuously buying in.

Despite market volatility, stock fund inflow remained positive for the 16th consecutive week, and even increased compared to the previous week. The inflow of bond funds, however, has slowed down.

The subjective investor’s allocation has dropped from a relatively high level to slightly below the average level (36th percentile). The allocation of systematic strategies has also dropped from a relatively high level to slightly below the average level (38th percentile) for the first time since the large pullback last summer: 01928374656574839201

This Monday, the VIX index experienced a Fluctuation of more than 40 points within a day, setting a historical record. However, considering that the market’s Fluctuation on Monday was less than 3%, historically, when the VIX jumps 20 points in a day, the stock market’s SpotFluctuation can reach 5% to 10%. Therefore, Goldman Sachs commented that this is a “vol market shock, not a stock market shock”. There are Liquidity issues in the VIX market, and the panic in the Derivatives market has been magnified. The market may remain volatile before the VIX expiration on August 21st.

Goldman Sachs’ brokerage department’s statistics show that clients net sold funds for the third consecutive week last week, while individual stocks saw the largest net buying in six months, especially in the information technology, consumer essentials, industrial, communication services, and financial zone. It seems to suggest that if the economic data is relatively optimistic, investors may shift their focus from the market’s overall risk (market beta) to specific opportunities in individual stocks or industries (alpha).

US stock Liquidity is at its lowest level since May last year:

Bank of America’s CTA strategy model shows that US CTA funds are inclined to increase the position in the next week. As the long-term trend of US stocks is still optimistic, CTAs are unlikely to switch to shorts quickly. Instead, they may quickly rebuild long positions in stocks after finding support in the stock market.

Japanese stocks tend to reduce position:

Upcoming Key Events

• Consumer Price Index (CPI): It is expected that CPI data will have an impact on the market. If CPI meets expectations or is below expectations, the market may not react significantly. If CPI is higher than expected, it will be a major concern.
• Retail sales data: If the data is strong, the market may take an optimistic view of a soft landing.
• Jackson Hole meeting: The Fed is expected to convey support for the market and may also mention financial tightening.
• NVIDIA financial report: It is expected to release the financial report at the end of the month, and the market may take a positive attitude towards its performance.