The market gave back some of its late-August gains last week, as both dollar and rates strength continued to weigh on risk.

The week was light on data, but heavy with macro concerns emanating from Europe and China. 

European economic reports were near-uniformly below expectations last week, with French industrial production being the lone bright spot.  

Meanwhile, Apple took a hit on the news that China is banning iPhones at work for government workers. 

While light on data, it was a busy week for Fed speakers. But their jawboning did not materially move the market’s pricing of future Fed rate hikes, which currently suggests (albeit by a slim margin) the Fed is done raising rates. (Though we should note the market has been wrong on several occasions throughout this hiking cycle.)

Next week should inject an ample dose of volatility into markets with inflation reports, retail sales, and the quarterly “quad-witching” options expiration. 

We will likely get either an amplification of recent movements (dollar higher, equities lower) or a trend change (dollar lower, equities higher). Recall the mid-July inflation report, which was quite cool, marked the interim bottom in the dollar (and it has been up every week since).  

Investor positioning remained largely unchanged. 

Equities: Composite equity relative sentiment fell from 72% to 65% and looks to have additional downside potential in coming weeks, but for the time being remains moderately bullish. Cross-asset positioning also remains favorable for the time being, but investor positioning in fixed income is shifting in a bearish direction. 

Dollar: The Smart Money continues to sell the dollar and has pushed dollar relative sentiment further into bearish territory. Consequently, it’s reasonable to believe the recent dollar rally is a countertrend correction rather than a new bull phase. While recent moves in oil might be cause for concern as we head into this week’s inflation reports, the fact the Smart Money continues to sell the dollar the higher it goes suggests inflation might be set to come in cooler than expected. 

Gold: While institutions had been aggressively covering shorts from mid-July through mid-August, the past two weeks they have been aggressively re-shorting, and gold relative sentiment has dipped further back into bearish territory. Thus, we would expect gold to remain choppy until either real rates momentum turns negative or institutions become relatively bullish on gold. 

The Bull Case

The bull case for equities remains largely unchanged:

• Momentum: We are still downwind from several momentum triggers and breadth thrusts from earlier in the year–the windows over which they tend to act would take us into Q1/Q2 2024

• Relative sentiment: While retreating from a solidly bullish 72% last week, composite equity relative sentiment remains moderately bullish at 65% 

• Retail Bearishness: Retail investors have been buying puts, while corporate insiders have been buying their own stocks (these signals tends to act over multi-week, multi-month horizons)

• Tech leading again: The chart of the ratio of the S&P 500 to the Nasdaq 100 looks to be in a bear flag that is breaking lower–this implies equities will move higher with technology stocks again leading the way

• September: Though September has been unconditionally the worst month of the year for the stock market, when the market has been up strongly through July or the VIX has been below 14 in August (both of which occurred this year), September has tended to be a good month for the market

The Bear Case

The bear case for equities adds a pillar:

• Valuations: 10-year expected annualized (nominal) U.S. equity returns ended the week at 2.4%, while the 10-year U.S. Treasury yield closed at 4.33%. Thus, holding 10-year Treasuries over the next decade is likely to produce higher returns than holding U.S. equities over the next 10 years. 

• Fiscal dominance: The Washington Post ran an article last week about the rarity of both increasing GDP and increasing deficits–usually tax-receipts increase during periods of GDP growth. But not now, as higher rates increase the interest expense on debt, which leads to higher deficits.  Exacerbating the problem, 31% of U.S. debt ($7.6 trillion) needs to be refinanced over the next 12 months at the now-higher rates. 

• The Calm before the Storm? The Market Ear, whom we respect for their cross-asset and macro analysis, says they are “leaning to be long” equity volatility given the unnatural calmness we have seen in recent weeks. 

To wit, the S&P 500 has gone 93 trading days without a 1.5% loss, something that has happened only 5 times in 15 years (although three of those five times the day-count continued higher into the low-to-mid 100s). 

Echoing that view, Nick Colas of DataTrek writes: “Corporate bond spreads remain very tight, which says that market remains very optimistic about future earnings. In the meantime, real Treasury yields remain near +10-year highs and look like they want to go higher. Against that backdrop, equity market volatility remains low. Stitch together those market narratives, and the near-term picture feels cloudy. Not stormy, necessarily … But certainly cloudy.”

One potential spark that could light the volatility fire is that options dealers are back to being short gamma as we head into a big week of data and quad-witching options expiration. That means the dealers have to sell as the market moves lower and buy if the market moves higher–thereby reinforcing any underlying move. 

Our View

We continue to believe the equity market has unfinished business at higher prices despite the burgeoning bear case. The combination of positive longer-term momentum plus bullish relative sentiment tends to lead to markets that drift higher at a moderate, but not torrid pace. 

Two consecutive weeks of aggregate equity purchases by institutions as retail sells is not the type of behavior typically observed at market tops.

That said, our conviction is not as high as in recent weeks. 

The potential for oil to continue to increase and put upward pressure on yields and thus upward pressure on the dollar, along with the potential for Apple, the biggest weight in the broad market, to languish are developments worth watching. 

Moreover, the concern over depressed equity volatility and the potential for it to rise (especially with options dealers short gamma) is legitimate. 

But with the Smart Money buying equities and selling the dollar leading into this week’s inflation reports, that would appear to suggest the odds continue to favor higher equity prices in the weeks to come.