Updated May 18, 2023

Market Risk May Have Just Become Two-Sided

Yet another range-bound week for equities last week. The S&P 500 was essentially unchanged and has now traded within a 3% low-to-high range for the last 29 trading days–a situation Goldman Sachs’ trader, Scott Rubner, calls “Groundhog’s Day.” 

Inflation came in slightly dovish to expectations mid-week, jobless claims spiked on Thursday, and consumer sentiment was a big miss to the downside on Friday.

Despite this slew of bearish growth data, longer-term yields surged on Friday. (Is the market suggesting more inflation is coming?) 

The Fed’s balance sheet increased last week, which may have helped the Nasdaq eke out yet another weekly gain (+0.7%).

This week is the regular monthly options expiration on Friday. As such, we would expect head-scratching cross-asset behavior during the week. 

Thus, we may have to wait until the following week to get more clues as to where markets go from here. 

The Bull Case

For nearly a year, the bull case for equities has largely rested on the fact institutions have been more bullish than retail investors. That is still the case. 

In fact, any time the 50-week moving average of retail investors’ net equity position was as bearish as it is now, equities rallied strongly

And thus, we should be open to the possibility of a strong rally from here. Such a rally would mesh nicely with the multiple breadth thrusts that triggered earlier in the year. 

But beyond retail positioning and breadth thrusts, other bullish considerations include: 

  • Megacap tech stocks are trading on the AI narrative, which states that profit margins will increase as labor costs decrease on account of AI replacing human workers. According to Barclays, profit margins appear to have bottomed in Q4 ‘22 and are now starting to rise (in line with the AI narrative). 

  • In the same vein, while relative sentiment in many sectors, industries, and asset classes has started to turn neutral or even bearish in recent weeks, Nasdaq relative sentiment has been consistently bullish since late 2022 and does not seem to be in danger of flipping anytime soon. Thus, megacap tech may continue to drag everything else higher. 

  • Based on expectations, earnings growth for the S&P 500 ex-Energy has bottomed and will only increase from here–and markets tend to like a positive rate of change for earnings growth.

  • Despite the recent dollar bounce, dollar relative sentiment is still bearish. And while it remains bearish it has the potential to support risk assets.

  • The post-earnings window for corporations to buy back their own stocks is open again. 

The Bear Case

While the relative positioning between institutions and retail investors has been the foundation of the bull case for nearly a year–the bullish nature of that relative positioning appears to be losing steam. 

While institutions are net long equities and retail traders are net short equities, and while institutions have continued to buy and retail traders have continued to sell, the rate at which institutions are buying and retail is selling is much lower now than virtually anytime in the last year. 

Thus, relatively speaking, institutions are less bullish compared to retail investors now than they have been since a brief period in mid-December 2022 (and June 2022 before that). 

On top of waning relative sentiment, the entirety of the year-to-date market rally has been driven by only a handful of megacap tech stocks. 

I.e., market breadth has been exceedingly narrow. While it’s possible the rest of the market will catch up to tech, it seems more probable (although hardly a given) that tech will catch down to the market–if so, that would likely drag the broad indices lower as well. 

Waning relative sentiment and narrow breadth are hardly the only bearish catalysts, however. Others include:

  • The coming debt-ceiling debacle–we assume politicians will drag out negotiations to the last minute, which markets might not like

  • Bank of America (BofA) forecasts a 65% chance of a recession–every prior forecast this high has been accompanied by an eventual recession. Given Friday’s consumer sentiment number, the likely contraction of credit from the bank crisis, and the lagged effects of previous Fed rate hikes, it would be remarkable if the economy were somehow able to dodge a recession. 

  • The market is forecasting that the Fed will cut rates later this year–which on its face may seem bullish. But if the Fed were to cut rates this year, it would likely only happen in response to some type of economic calamity–i.e., something that would have the power to knee-cap equities. 

  • Retail sentiment in commodities is plumbing levels that tend to suggest slowing growth, recession, or deflation–all headwinds for equities. 

  • CTAs, i.e., trend followers, have been forced buyers the last several months. But if the market turns down only marginally, they could soon become forced sellers of as much as $200 billion. 

Our View

We have been resolutely bullish–on account of bullish relative sentiment–virtually nonstop since Q3 2022. 

Yet despite there being plenty of supporting evidence for a continued bull thesis, we are taking a neutral stance here.

This shift in our outlook largely stems from a shift in investor positioning in long-duration bonds and along the yield curve. 

Since the last Fed meeting in early May (just two weeks ago), institutions have been taking an aggressively bearish position in long duration bonds. 

Because we believe we’re in an inflation-driven regime in which equities and bonds will have positive correlation, if the smart money is positioning for bonds to fall, that’s an under-the-radar indication they expect equities to fall as well. 

To be sure, institutions’ combined positioning in equities, long-duration bonds, and along the yield curve is STILL in a bullish state relative to retail investors. 

BUT…at the rate it is trending bearish, it could flip negative in as little as two weeks’ time (and sooner if that rate accelerates). 

Even if it does turn bearish, however, the smart money often positions themselves defensively a bit early. Which is to say, equities could continue to drift higher or even squeeze higher before ultimately rolling over. 

Thus, it would not surprise us to see equities continue to rally in the near term, especially if it coincided with a more bullish narrative (e.g., AI, better than expected earnings) to entice retail traders back into the market. 

But with institutions sneakily shorting bonds rather than stocks, downside risk in the broad equity market now seems to be comparable to upside risk. 

Hence, our neutral outlook. 

Allio Portfolio Updates

No change to Allio’s portfolios. We continue to be tilted strategically for the prevailing secular regime and tactically to the Nasdaq 100 (on account of investor positioning and its strong technical condition). 

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