Entering the strongest seasonal quarter

Equity and Other markets review 10.10-16.10.2022

General overview: Last week provided some great volatility. Despite Monday’s hard wake-up by TSLA’s premarket action and the Credit Suisse panic, the market had a great day that was the start of a beautiful 2 day squeeze. I won’t go deep into this, but the best signal for a change in momentum comes when bad news do not affect a tired market. And for a moment everything looked like we can kiss the 3900 lvl. Then strong jobs came along and crushed all hopes for a pause. OPEC+ decision to cut production, combined with strong price action from oil, heating oil and probably soon gasoline could not have been more disheartening for those thinking a pause is around the corner too. We erased all the large gains in the beginning of the week only to finish it mildly positive. I entered last week with a short dated long put spread 3550-3500 that I quickly tossed for a loss. Nevertheless, I have learned that in bear markets, when there is a weak close on Friday near recent lows, one should either be net short or cash (even on rebalancing days). This week we finished in a similar way, so I made sure I got rid of everything that would leave me net long equities. However, I am far from being wildly bearish. We have still not broken the recent lows and even though chances are increasingly positive for doing so, there is little change in the good technical levels that are slightly beneath. Between 3600 and 3500 lie the weekly 200 and the monthly 50 moving averages, as well as the key level 3500.

Rates have not looked back and continue the frightening trend they are on and so does the dollar. I might be overoptimistic here but I think the DXY could have made a short term top. The highs seem further away than those in rates and the lows in SPX. And we had the extended volatility moves in GBPUSD and EURUSD that are usually seen at the end of big moves.

And probably, most important, the Barron’s cover for this week for all about the dollar. We all know it, when it gets to front page, the trade is almost always done.

I know everyone is nervous about this earnings season. And probably rightfully so. I was nervous for the Q2 earnings season, and it turned out that it was better than expected. While I will restrain from having any expectation on how good or bad the upcoming earnings will be this time, I do believe they are important as a catalyst for the direction of SPX. Also, I think it is important to note that some of the largest companies have already stated either disappointing preliminary Q3 results or some demand weakness. Just to name a few here: FDX, WMT, HD, NVDA, KMX, NKE, CCL, MU, AAPL, TSLA and on Friday, AMD. Summing up the market cap of those is not necessary for one to acknowledge that worsening fundamentals have already started being priced in within SPX. We kick-off the season this with the following:

Sector review: Last week we saw a striking divergence between the sectors. Those that have been showing relative weakness recently, such as XLP, VNQ, XLU and XLK continue to underperform, whereas those that benefit from the inflation/commodity narrative - XLE and XME - did very well. The CRB index had a great week, respectively.

And for those who think the CRB is all energy related, here are the different weights:

I am not too sure if we are going to witness the commodity narrative vol. 2, but I would not be surprise if we do. Energy and other commodities have had a decent pullback, gold and silver bounced off the lows swiftly and will be beneficiaries when the pause eventually comes and there is a huge crowd of investors bullish on coal, aluminum, copper, uranium, etc eyeing short-term catalysts such a China reopening or long-term structural deficits. Weakness in the dollar would be bullish and the price action of commodities themselves has recently served those investors well.

Potential trades: While the above was a little ode to the commodities play, I would rather focus this part on a seasonal phenomenon in SPX. The timing of this one would be hard and has not yet come, but I expect that soon might be the moment to get long equities. A lot of people have written that there are a lot of bear markets that end in October. I am unsure whether the current one will, even when adding to it facts that October has a positive seasonality in Midterm years.

However, I am more interested in the super strong performance of equities historically in Q4. Here is a chart from our seasonality tool, which shows that since 1993, the period between October and December was positive in c. 80% of the years.

Average and median performance are 5.16% and 7.06%, respectively. What most people hear and know of is the so called “Santa Clause” rally in late December. But if one looks closer at the chart, the slope of cumulative returns for the period October - December is no different than the slope in December, meaning that on average they share similar seasonality effect. While the saying “Bull market are born on pessimism” is true, I would definitely consider a stretch at the moment every call for an end of the bear market. We are far from getting the clouds dispersed but there is a plethora of professional investors who appear to have made most of its returns in Q4, and they will certainly be looking for it again this year.

Add to this the moral hazards that come if they are down on the year. Harris Kupperman (@hkuppy) has spent quite some time on twitter around this topic. They have a huge career risk at the moment, which incentivizes ‘all in’ behavior on the long side in an effort for a mutual window dressing. I know this sounds vastly speculative, but cannot argue there is truth behind the hypothesis.

Current positions: I am long IWM against SPY (through futures), long PDD Nov 80-90 call spread with a 1/2 size and a full short position in DOCU through put spreads.

I am long IWM vs SPY, following the recent outperformance of small vs large caps that I see continuing. More about the trade could be found in our last week’s equity market overview.

My long call spread in PDD will not be discussed as I have forgotten to post it publicly live on twitter, as I always do, aiming for full transparency on our trades.

I got long put spreads in DOCU prior to Friday’s job release. I was looking for a hedge to my SPX call flies, which I got rid of later on Friday. However, I kept my Oct 21 51-47 and Nov 50 - 40 put spreads, as they performed as planned - gap under support (50$) and continued sell-off throughout the day. DOCU has been one of the weakest tickers around with poor fundamentals and price action and deserved. Therefore, it made sense to include it as a short for the binary event.

Conclusion: We are entering this week with a slightly net short exposure on our portfolio, give Friday’s events. However, I am not overly bearish and plan to further decrease my book heading into this week’s CPI, as I have no clue how it would affect markets. Earnings season is knocking on the door already and could give an impulse into for a direction, but some weakness is already priced in by publicly available news of bad preliminary earnings and weak demand. Q4 is seasonally the best quarter for bulls and I am positive for a good bounce coming until year end. Timing will be key so stick around.