BOE blinked

Weekly equity and other markets review 03.10-07.10.2022

General overview: Last week’s result for SPX came in a negative c.3%. While such moves do happen on a single day, especially when VIX is at high levels, one would easily say that the past several days were anything but boring. Bank of England was the first to ‘blink’ amongst the biggest central banks on their agenda to fight inflation and shrink their balance sheets. It turned out that instead of quatitative tightening as previously planned, it would actually do a £65bn bond-buying programme to stem a crisis in it’s government debt market. For the first time since the world central banks started fighting easy financial conditions and inflation, cracks in markets started appearing. We have an old saying in Bulgarian - “Тебе думам дъще, сещай се снахо”. It meaning is hard to convey but the rough translation goes as “I’m talking to you, my daughter, so think hard, my daughter-in-law”. It usually serves the purpose of conveying in a polite way a message to its rightful recipient (the daugther-in-law). And it could very well be true that while the market is telling BOE that the rate of change of its rates and the amount of tightening is too much for the system to handle, the FED should think hard and take notice. And this is how US investors actually understood it. Rates topped exactly on Wednesday, when BOE intervened and have been digesting this nuance in recent market developments.

The dollar was no different, letting not only the EUR and other currencies advance against him, but even GBP, whose movement made little sense to people given the inflationary characteristics the BOE easing carries. Yes, it is a temporary intervention and it would not directly affect the rise of prices. But its signaling effect as to how stuck the BOE is right now matters much more.

Despite both the rates and the dollar giving some room for the broad indices to breathe, SPX continued to show weakness after Wednesday and finished the week on the lows. I am uncertain to what extent the poor price action was due to market structure (JPM’s 3580 put, EOQ rebalancing). However, it now trades in an area where key technical indicators are located (sma200 on the weekly, near sma50 on the monthly) and given its oversold conditions I am facing a hard dilemma. On one hand, if there continues to be a lack of bidding at this key levels, I would be tempted to go short for the last part of the leg where volatility and price movements extend. On the other, there is the obvious case for a bounce from good levels with a bit of tailwind from bonds and the dollar.

Sector overview: Not less interesting was the development amongst sector ETFs. The energy related equities finally bounced with oil sitting on its weekly sma100. During the weekend came the OPEC news for a planned cut which would further give the sector some ‘fuel’ to the upside. However, with global growth slowing down and recession around the corner (if not already here), the upside is rather limited.

An industry that caught my attention with stronger than expected price action is GDX (gold miners). Gold has been a direct beneficiary of both the drop in rates and the dollar since Wednesday. While its price action has not been impressive at all, I registered that GDX is now above the beginning of Sep levels, when gold was hovering around 1700. I will keep an eye on the sector in case the FED has taken note of the developments around BOE and, eventually, changes the tone to something less hawkish. Precious metals and related equities could be great beneficiaries of such scenario.

The standout loser from last week is the utilities. I admit I am not too sure why the price action was that appalling. Could be weather related, simply a fast recalibration of where it should be trading vs other defensive sectors and overall rates levels or a massive selling related to rebalancing. No matter what the cause was, it dropped nearly 9% for the week and was the worst performing sector. The area 64.5-65$ has been the low for the year and appears to be good support for those aiming to get a bounce from oversold conditions.

Last but not least, one should take a look at the destruction in RE related ETFs that has continued. When calling the sell-off in REM, no one amongst us was thinking it would be so fast and so aggressive and thus our play turned out to be suboptimal to say the least. When the sun shines again on the broader indices and these names get the tailwind, my shorts will most likely be focused on this sector again.

Potential trades: For those reading our writings, it does not come as a surprise that we usually paint a gray picture around large caps stocks due to their valuation. Previously, I have proposed RSP vs SPY as a pair trade as a way to lean smoothly into the underperformance of the heavy weights in SPY. The potential trade I will present now has some similarities, but it is based on the relative cheapness in the valuation of Russell 2000 stocks.

As much as I hate referencing historical extremes in stock markets, such as the dot.com bubble, the chart speaks for itself. Small caps appear to be quite cheap compared to large caps on average over a long period of time. The only moment they were cheaper was in 2000 and betting on them turned out to be the theme of the decade, before the GFC hit. I am not advocating a similar move in time and magnitude, but we have this divergence from the mean. What is more, the price action of the IWM (Russell 2000 ETF) vs IWB (Russell 1000 ETF) has been very constructive too in 2022.

The pair bottomed in Feb 22 and retested the lows in May. Since then, it has been making higher lows with a rather messy price action. If one looks at the individual charts of IWM and IWB, the latter broke its recent lows while the former is still trying to defend the recent bottom.

I realize the pair could serve the purpose of a higher beta trade that performs well in a upside market and this is fine. What I like about it, is that it has not performed like that on the downside, especially since May. When I think about the construction itself, I am very tempted to try it out as it can Russell 1000 could well be replaced by S&P 500 as a proxy. Both Russell 2000 and S&P 500 indices have futures (RTY and ES) and making the trade through futures would save a ton of money by eliminated short costs, dividend complications and fees on margin.

Current positions: We are short SPX.

We have no other equity related exposure but a short term long 5 Oct put spread 3550 - 3500, which aims to profit from a continued sell-off on Monday following the ugly close that we had on Friday.

Conclusion: We are a point where cracks in the markets started appearing. BOE was the first but probably not the last (if we stay the course) institution to make a swift change in its policies in order to save the day. US markets show signs of discounting such possibilities as both rates and the dollar fell after Wednesday. SPX is at key technical levels where a bounce is logical but if it fails to materialize, a sudden spike in volatility could happen. I keep my exposure light-to-none and wait to gain further conviction to position myself accordingly.