Cycle Capital Macro Weekly Report (8.12): US stocks' excessive 'recession trade' wrongfully kills mainstream Cryptocurrency

The biggest week of Fluctuation in 2019

Although the US stock market was basically flat for the week, the market was truly a roller coaster ride.

On Monday, there was a panic dumping, a retaliatory rebound on Tuesday, a technical sell-off on Wednesday that caused the market to plummet again, and on Thursday, the first-time jobless claims, which had a moderate impact, triggered the urge to catch the bottom in the market, although this data is not worth excessive excitement, as the trend of continuously increasing initial jobless claims is evident. 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. The core themes in the media are the recession in the United States and the resolution of the Arbitrage trading in Japanese yen, but I personally believe that 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 of the US stock market on Monday, there was a peak-valley Fluctuation of about 4.5%, making it the largest Fluctuation since the 2019 COVID-19 panic. Fluctuation implies risk but also 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 reason is

• 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 types of data have been proven to be unreliable in this recovery cycle.
• Enterprise profit rise situation is good, just the magnitude of exceeding expectations did not expand.
• Secondly, it is impossible for Japan to continue raising interest rates, because the huge debt cannot be digested by economic rise.

• The short-term panic of unexpected interest rate hikes triggered the unwinding of the previous excessive leverage, and such stampede is estimated to have been digested by Monday according to data.
• The trends in the fixed income and USD forex markets dominated by big players do not match the conditions of panic trading or Liquidity scarcity

So it can be concluded that Monday is more likely to be an accidental mistake.

However, further observation of the data changes is still needed. It is too early to say that everything is back to normal now. After all, from the perspective of fund preference, the aggressive vs. defensive stance has not changed, and the disappointment with big tech has escalated to a ‘killing narrative’ level (the three stages of declining: performance, valuation, and narrative, are becoming more severe). Unless NV’s financial report can once again shatter all doubts and stir up industry sentiment, so the US30 and US500 may outperform the US100 in the coming months. However, recently, the extent to which Cyclical has lagged behind defensive in terms of trading is quite large, and there is a possibility that the short-term Rebound may be even greater.

Goldman Sachs clients bought tech stocks at the lowest level last week, with the volume reaching the highest in 5 months:

On the other hand, bond prices pump, the Interest Rate falls, providing a buffer for the stock market’s fall. In the past month, the US 10Y has dropped from 4.5% to 3.7%, an 80bp change that far exceeds the expected decrease due to interest rate cuts. Unless a recession is truly imminent, such pricing seems to be an opportunity, just like the market enthusiasm for interest rate cuts in the fourth quarter of last year (falling from 5% 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 stock market’s pullback from the historical high has recently started, with a maximum magnitude of only 8%. The current level is still 12% higher than the beginning of the year. Due to the pump of bonds, investors with a high degree of diversification will not be solely affected by the overall decline in the stock index. Therefore, the situation of chain dumping in the US stock market is not worth worrying too much about. On average, over the past few decades, we have experienced approximately 3 adjustments of 5% or more each year, and one 10% adjustment.

If the stock market’s decline and adjustment are not accompanied by economic or corporate profit declines, they are often temporary, followed by a good upward trend:

However, considering that the pessimistic sentiment of technology narrative is unlikely to reverse quickly, and the short-term drastic Fluctuation has caused significant damage to many investment portfolios, there is still a need for medium and long-term funds to adjust their positions. The short-term Fluctuation may not have ended completely, but it is unlikely that the market will begin 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 perspective of the relative historical adjustments of various assets, due to the more falls in metals, the more rises in government bonds, and the fewer falls in stocks, the recession expectations reflected in the government bond and commodity markets are even greater than those in the stock and corporate bond markets.

91% of the companies in the S&P 500 have published their Q2 financial reports, among which 55% have exceeded their 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 performance of the health care, industrials, and information technology industries is relatively good, with a higher proportion of companies exceeding expectations, while the performance of the energy and real estate industries is relatively poor.

NVIDIA’s valuation has pulled back:

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

The financial reports of large technology companies this quarter are solid, there isn’t actually any performance decline, the decline in valuation is mainly due to increased investment in AI.

Palantir raised guidance, emphasizing AI boosting performance, with a 37% big pump in stock price, sparking some AI narrative discussions on the street.

About the Expected Interest Rate Cut in September

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

In terms of market pricing, the normal rate cut at the September FOMC meeting will be 25 basis points, but market expectations may exceed 25 basis points. In Monday’s trading, due to panic, it was priced at 63bp at one point, but eventually closed at 38bp this week. In addition, the current market has already priced in the expectation of a 100 basis point rate cut by the Fed this year, which is equivalent to four times.

The first time the expected deterioration in data exceeds 25bp and three times within the year, especially data on the job market to support, otherwise this pricing may be excessive. If the data supports it, the market will gradually price in the possibility of a 50bp rate cut in September or even a 125bp rate cut within the year.

From a trading strategy perspective, in the short term within two weeks, the US Interest Rate market is mainly in a pullback mode when it rises, and in a bet on the decline mode for periods of more than one month because the interest rate reduction cycle is bound to begin. It will take time to improve the Consensus on whether the rise in unemployment rate indicates economic slowdown and potential recession, and during this period, there will be continuous fluctuations in emotions.

The remarks of the Fed officials last week were slightly dovish, but overall non-committal, which was expected.

encryption Market

After experiencing the most severe pullback since the FTX crisis, the price of BTC has rebounded after falling more than 15%. The trigger factor for this pullback is not an internal event in the cryptocurrency market, but an external impact from the adjustment of the traditional market. The technical aspect is also severely oversold, similar to the situation in August 2019 when BTC dropped from 29,000 to 24,000, followed by two months of consolidation.

So it can be understood why encryptionRebound’s momentum is so fierce.

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

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

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

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

Several factors may keep institutional investors optimistic:

• Morgan Stanley recently allowed its financial advisors to recommend BTC spot ETFs to clients. The liquidation pressure from Cryptocurrency payments in the Mt. Gox and Genesis bankruptcy cases may have passed.
• The payment of over 10 billion US dollars in cash after FTX’s bankruptcy 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 the sharp increase in bond allocation in 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 the 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, which indicates that more of their funds are concentrated in stocks and bonds. A low cash allocation may increase the market’s vulnerability to pressure, as investors may need to sell assets to obtain cash when the market falls, which could exacerbate 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 recent market fluctuations, retail investors have responded relatively mildly, and there has not been a large-scale withdrawal of funds:

Retail investor sentiment survey still remains predominantly positive:

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

The speculative net short position in Japanese Yen (blue line in the chart below) had basically returned to zero as of last Tuesday:

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

Yen Arbitrage trading mainly consists of three parts:

1. The first part is about foreign investors buying Japanese stocks. For safety reasons, they will make a Derivatives selling an equivalent amount of yen. Recently, due to the pump of yen and the decline of Japanese stocks, these investors have suffered losses on both sides and have to Close Position the entire portfolio. According to the Japanese government’s statistics, the amount of foreign investment in Japanese stocks is estimated to be around 600 billion US dollars.

2. The second part is for foreign investors to borrow yen to buy assets abroad, such as stocks and bonds. It is calculated according to the total yen credit to non-bank borrowers outside Japan by the bank for international settlements. This operation had a total of about 420 billion U.S. dollars at the end of the first quarter of 2014. However, the relevant data is only updated quarterly, and the data for the second quarter is not yet available.

3. The third part is domestic investors, that is, Japan’s own investors using yen to buy foreign stocks and bonds. For example, Japan’s retirement funds will use yen to buy foreign stocks and bonds for future payments. This type of transaction had about 35 trillion US dollars before the adjustment, with approximately 60% in foreign stocks.

If we add these three parts together, the total volume of yen Arbitrage trading is estimated to be about 4 trillion US dollars. If Japan’s inflation situation in the future forces the Central Bank of Japan to raise interest rates, this type of trading will gradually decrease. So this is why short-term positions may be unwound but long-term positions may still have an impact.

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

1. Trend followers or speculative investors (such as CTAs): recently, they have had to sell a large number of long positions in stocks they previously held and short positions in the Japanese yen.
2. 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 trade has not been significantly unwound.
3. Risk Parity Fund: Recently, there has been significant Fluctuation in the market, and they are also reducing their investments, but less so than CTAs. However, the pump in bond prices has helped them control the losses.
4. Ordinary retail investor: Compared with previous stock market downturns, their withdrawal this time is not significant.

Since the end of May, a total of 31 billion USD has flowed into China-themed funds, with passive funds continuing to buy.

Despite the market turbulence, stock funds have maintained a positive inflow for the 16th consecutive week, and even increased compared to the previous week. The inflow of bond funds, on the other hand, has slowed down.

The subjective investors’ 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 after the big pullback last summer.

On Monday of this week, the VIX index experienced a Fluctuation of more than 40 points within a day, setting a historical record. However, considering that the overall market Fluctuation on Monday was less than 3%, historically, when the VIX jumps 20 points in a day, the stock market Spot Fluctuation can reach 5% to 10%. Therefore, Goldman Sachs Trading Desk 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 amplified. The market may remain volatile until the VIX expiration on August 21st.

Goldman Sachs’ brokerage division’s statistical clients sold net for the third consecutive week to fund products, while individual stocks saw the largest net buying in six months, especially in the information technology, essential consumer goods, industrial, communication services, and financial zones. This seems to suggest that if the economic data is relatively optimistic, investors may shift their focus from the overall market risk (market beta) to individual stocks or industry-specific opportunities (alpha).

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

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

The Japanese stock market tends 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 lower than expected, the market may not react too much; if CPI is higher than expected, it will be a major issue.
• Retail sales data: If the data is strong, the market may take an optimistic view of a soft landing.
• Jackson Hole Conference: The Federal Reserve is expected to convey support for the market and may also mention the tightening of financial conditions.
• 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.