The broad equity market fell for the second straight week last week, albeit small. The Nasdaq 100, on the other hand, fell 1.5%, marking the first time in 2023 that the tech-heavy index has fallen for two consecutive weeks (it is now off 6% from its July 19 high).

The dollar rose 0.80%, and commodities increased 0.50%, while gold and silver fell 1.5% and 4%, respectively.

Interest rates continued to climb. The 10-year U.S. Treasury yield rose 11 basis points, while the 30-year yield rose 6 basis points. 

The big news last week was CPI and PPI. On Thursday, the former came in roughly as expected. But on Friday, the latter came in hot and caused the market to give a slightly higher probability (though much less than 50%) to the prospect of the Fed raising interest rates one more time.

The general tone of the market appears to have shifted these past two weeks–from invincible bullishness to nascent vulnerability. From their recent highs, former juggernauts such as Nvidia and Tesla are down 16% and 20%, respectively. Microsoft, 11%. Meta and Apple, 9%. 

But given the manic runup in equities and the sub-optimal liquidity and seasonality of August, the current pullback in these names (and the broader market) makes ample sense. 

Interestingly, other sectors appear to be picking up the mega-cap tech slack. First and foremost among these is the energy sector (which has risen 16% relative to the tech sector since July 19), as commodities and particularly oil continue to catch a bid. (This despite the factor relative sentiment in the energy sector continues to register as bearish.)

On the investor-positioning front:

• Cross-asset relative sentiment in equities turned bullish last week for nearly all equity indices, regions, sectors, and countries (with some notable exceptions, such as emerging markets, energy, and utilities). 

• Dollar relative sentiment remains bearish, but continues its dance where it flirts with turning bullish. Whichever way the dollar ends up going will likely determine the subsequent path for every other asset. 

• Institutions continued to buy gold and silver last week, yet retail investors continued to buy those precious metals even more on a relative basis, leaving gold relative sentiment stuck in neutral and silver relative sentiment at extremely bearish levels. 

Last week our expectation was for the pullback in equities to continue. Now that it has, where do we go from here?

The Bull Case

The bull case continues to rest on strong momentum and favorable cross-asset positioning. 

Institutions are relatively bullish growth-related assets again (after a two-week period in which they were relatively bearish) and continue to position themselves for financial conditions to ease. 

From a technical perspective, equity indices appear to be tracing out bull flag patterns, which tend to resolve with prices moving higher.

The National Association of Active Investment Managers’ (NAAIM) latest exposure survey indicates that active managers lowered their equity exposure from 101% two weeks ago to 65% last week. 

The 36 percentage point drop is at the second percentile of historical values. In the prior 21 times active managers have dropped their equity exposure that much in a two-week period, the market was higher one month later 16 times, lower four times, and flat once, for an 80% winning percentage. In comparison, the likelihood of any one-month period being positive is only 66%.  

(It should be noted, however, that two of the four down periods were large down moves. One occurred from early-March to early-April 2020 and the other from mid-May to mid-June 2022.)

Lastly, the corporate buyback window is now open post-earnings and the expected daily buyback volume is $5 billion, which may provide a steady bid for stocks. 

The Bear Case

The bear case remains roughly similar to last week:

• Valuations remain extremely unattractive, with an expected risk premium relative to 10-year U.S. Treasury Notes of -187 basis points. Moreover, tech sector valuations are at the same levels as the peak of the market in 2021 despite financial conditions being much tighter now.

• Long-term interest rates continue to climb and (perhaps more importantly) real 10-year interest rates are at 1.80%, the highest since 2009. 

• According to The Market Ear, CTAs have lots of selling to do if equities continue to fall, as do options dealers, as do volatility-controlled funds (whose current equity exposure is at the 99th percentile of its distribution over the past 10 years). 

..with a few new additions:

• While cross-asset positioning is favorable for equities, direct positioning in equities is not favorable. Institutions resumed their selling last week and their relative positioning versus speculators and retail investors has become moderately bearish. 

• China–the data out of China looks bad and China experts seem to have a negative opinion of China’s prospects.

• Citi’s panic/euphoria sentiment indicator is nearing the euphoric region. This is notable because when the indicator reaches “euphoria,” the market has a better than 80% chance of being lower one-year forward (via The Market Ear). 

• M2 money supply in the U.S. is down more than 4% year-over-year. Negative M2 growth is rare and tends to be unfavorable for equities. (If the dollar rises, this might be the driving force behind it.)

• The cost to hedge against S&P 500 downside via puts is at its lowest level since records began (2008)–which suggests few are positioned for such a downside move. 

• The technical backdrops for several mega-cap tech stocks (e.g., NVDA, TSLA) suggest further downside risk.

• Retail sentiment in commodities is uniformly unfavorable. It is high in oil and broad commodities, suggesting inflationary headwinds, and it is low in lumber, which suggests growth is slowing. 

Our View

Zooming out, we continue to believe the market has not topped and will eventually resume its uptrend. This belief is based on the still-not-extreme relative positioning of institutions versus speculators and retail, along with moderately-to-strongly bullish composite relative sentiment and positive momentum. 

But over the near-term, we can’t rule out a further selloff. And because the more the market sells off, the more equities need to be sold (by CTAs, options dealers, etc.), it’s conceivable we could see non-trivial downside in the next couple weeks. 

If that waterfall effect does play out, almost certainly institutions would be on the other side of the selling, buying the market (since the investors that have to sell are non-institutions). And thus, we would expect the market to rebound strongly, should it fall sharply in the near-term. 

Allio Portfolio Updates

No change to Allio’s core or tactical portfolios last week.