The title of this week is not inspired by Jason Mraz, though this is a good song. It is inspired by my pastor, who starts each sermon saying: “three things”. He is referring to the lessons from the readings that day. He finds the organization and brevity helps keep people focused. I thought I would try the same approach in keeping it short, sweet and focused.
FUNDAMENTAL
You all know that the ISM is my favorite indicator. You all know why I, and many in the market, prefer it to GDP. I have written too many times about it. Well, we got ISM on Thursday. It was nothing short of shocking imho. The chart above is of the headline and the new orders to inventory ratio. The ratio had given a sign of life last month by bouncing, driven by a fall in inventories, not a pick-up in new orders. New orders continue to fall below expectations but now inventories are drawn down too. The internals of this number suggest very strongly that headline ISM heads lower. It was 46.8 this month, below expectations of 48.8, and barely above the recession level of 45. A few other things to point out. The ISM employment number plummeted to 43.4 vs. 49.2 expected. This is already recessionary. When we add to it the very poor continuing claims number, I really don’t care what non-farm payrolls says. That number will be revised three more times, and all revisions are negative. Yes, you might say, but at least inflation is falling, and the Fed can cut. Well, the ISM prices paid, which leads inflation, ROSE. This is a stagflationary number. It was horrible. I will leave it with one last note. I have shown the chart before. We know the best time to own stocks is when ISM is below 50 and rising i.e. times are bad but getting better. This was last year. Right now? ISM is below 50 and falling. This is the only time the returns for the stock market are negative. No bueno.
BEHAVIORAL
For my money, this is the story right now. Money is rotating. We are seeing de-risking across the board. The main source of funding for levered accounts is Japan. Borrow at close to 0% rates and watch the currency weaken. The only risk is … if the Yen strengthens. Well folks, in the last 3 weeks, the Yen has strengthened by 8.5%. Add onto that the BOJ is going to start hiking rates, which combined with expected Fed cuts, reduces desire to be long the pair. Levered funds take notice and are de-risking. We see the best performing asset is the short-interest basket. HF are cutting shorts. We saw before the massive closing of the gap between large caps (SPX) and small caps (RTY). About 12% of underperformance was closed in two weeks. TWO WEEKS. This isn’t healthy. This is de-risking at the highest level. Now look at the relative rotation graph. Previous high-fliers like crypto, precious metals, China and momentum are all in the weakening category in the lower right. This is the worst place to be. This means you were leading, people are overweight, and now you are lagging. The asset that people are flocking to right now? Bonds. They had lagged and are now improving. This is due to two things: 1. fears of a recession 2. Treasury keeping the market short duration, forcing investors to buy Treasuries since issuance at the front end. Again, not a healthy reason for yields to go lower. This de-risking has me a bit worried in illiquid summer markets.
CATALYST
What can get people to change their mind? What is the catalyst? Well, I logged onto Bloomberg on Thursday and started a conversation with a friend in the market that goes back to the early 90s and Asia. Collectively, I think we have seen it all. His first comment to me: “After what happened last night, I thought for sure we would be down. Instead, we are up big. This isn’t right.” He was referring to Israel launching rockets into Iran to take out a Hamas leader in response to the Hezbollah attack on Israel. I agree with him. This is a collection of what we have seen in the last 2 weeks:
Israel vs. All of the Middle East is escalating: Hezbollah now involved and not just Hamas. With a rocket fired into Iran, it will respond and not in the well-telegraphed way it did last time. This is going to get ugly.
Ukraine vs. Russia is getting uglier. Russia used hypersonic missiles to attack a Ukrainian arms depot. Ukraine used drones to attack a Russian artillery storage site. This will escalate before the ground-fighting stops for the winter. Another summer with few if any crops from the breadbasket of Europe as well.
Turkey does a massive assault on the northern Kurdish region. There are 30 million Kurds spread out across a number of countries. This escalation is a negative and not on anyone’s radar.
Venezuelan President (not) Maduro will not honor election results and then has the military fire on his own people. Many police resign on the spot. People fight back. Most shocking but accurate tweet I saw said simply: “You can vote your way into socialism, but you need to shoot your way out.”
Does this level of escalation happen if there is a strong US? I don’t think so. I am not taking political sides here. The consensus in DC is that the US should back out of the world. That is somewhat bi-partisan. Sure, Biden wanted more funding for Ukraine, but now Biden has gone AWOL. The market, and other leaders, look at the two candidates and thinks now is a great time to ramp up attacks. The US is going to do nothing about it.
That leads me to the chart today. I have shown you the VIX in the past. It has gone up a little. I said into the elections I thought it could rise. However, in light of everything that is going on in the world, implied volatility and other measures of risk are really muted. The charts here are VIX (equity volatility), MOVE (Treasury volatility), JPM VXY (FX volatility) and credit spreads. All are lower than early 2023 and well below the peak in late 2022. All suggest there aren’t many risks out there. Why do markets collectively not care about geopolitics? Some suggest it is the passive influence. I need to dig in more.
I look at all of this and I see very clearly negative Fundamentals, I see the Behavioral moving quite negative as funds are de-risking, and then I see on the Catalyst front negative headlines that are NOT getting priced into the risk markets. This makes me a bit nervous right now. This goes beyond just staying vigilant. This is a time to take action and protect your profits for the year. I don’t say that lightly. Be careful. It has been a good year. Don’t let it go by the wayside.
P.S.
For those who really want more content, and you know deep down I want to give you more, I am posting links to the blogs I wrote for Chart Advisor by Investopedia this week. I covered some of the same content on Linked In as well but went more into detail for Chart Advisor.
Next week I am doing a video with a long-time friend where we will have a Bloomberg open and just talk about markets. Something the two of us have been doing together for over two decades. It will be a little longer, which is why I wanted to keep this one on the shorter side. Have a great weekend and …
Stay Vigilant!!
Appreciate the words of wisdom (warning), Richard!
The warnings are playing out! Look forward to your assessment.