Weekly equity and other markets review 26.09-30.09

Short term capitulation near?

General market overview: The ugliness continued with full force last week. The beginning of the week started with the usual bidding (short covering) before an important update (FOMC). However, since the FED gave us a glimpse of the new meaning of higher for longer through the dot plot, the market went no bid. Culmination came on Friday, following the spike in UK rates, whose panicky feeling in my opinion got into other markets as well.

All the talk that some ‘doomsayers’ have been spreading about tail risks and contagion is now feeling closer than ever in 2022. The dollar wrecking ball is striking with full force and now parity with GBP, not EUR, feels like a touch away. I am always constructing my view of equities through the lenses of rates and the dollar and I have little good to talk about when I see this:

What feels most frightening is the rate of change. Last week was the best week for the dollar since March 2020. On the bright side, usually the moment when price of an asset is entering the parabolic phase of an uptrend, the high should be near. This conveniently comes as SPX is trading close to the sma200 on the weekly and sma50 on the monthly, which lie in the 3550-3600 zone. Reaching this zone would also require sacrificing those with stops under the June lows, and as we all know, markets love to hunt stops.

US rates are also running like they are being chased, especially the front end. Everything feels so shaky at the moment, that my spidey senses are sensing near-term capitulation. However, we are not there yet and the worst one could do here is go outright long with eyes closed. Patience, discipline to execute and risk management matter now more than ever.

Sector overview: The standouts from last week are definitely the energy related sectors. XLE fell c. 9% whereas higher beta sectors such as Oil services (OIH) and Oil and Gas E&P (XOP) fell double digit numbers, all following the huge weakness and downtrend in oil. The commodity continues failing to find support, which in an environment of tightened supply, speaks only of worsening global demand.

At least, real estate has not surprised us at all, and has now forgotten the good times it went through June’s low. Poor price action comes as expected, given how much higher rates are compared to a few months ago and the darkening clouds going forward for housing and the economy. The data centers DLR, EQIX, which are one of the larger equities in the VNQ ETF, are also trading at sky high valuations and have been participating in the short portfolio of one of the greatest short sellers out there - Jim Chanos.

On the other hand, the homebuilders (ITB) are acting rather strong, trading well above this year’s lows and even closing on Friday on a positive territory - the only industry that did so. It is a fascinating divergence and I find it rather stunning that with mortgage rates so high, the two largest companies in the sector - LEN and DHI - are looking much better than most other equities for a long setup from a technical / PA point of view.

Potential trades: I could have placed the development of regional banks (KRE) and big financial institutions (XLF) in the section above, but I feel more comfortable putting them here as a potential trade some might like. Last week, KRE finished down c. 4% whereas XLF was down c. 6%, which made me investigate a bit further. Since June lows, the regional banks have fared significantly better, and while XLF is retesting the lows, KRE is trading at a healthy distance from it.

When both are put on a ratio, XLF appears to be trading very cheap compared to KRE on a 1y horizon. To be exact, the ratio is currently at a 2 sigma deviation from its mean.

One might argue that a one year look-back period is not enough and while the picture is much less impressive going back 5 years, look how the pair long XLF and short KRE has performed in dire market conditions when recession was the main fear driving price action:

In late 2018 and early 2020, XLF significantly outperformed KRE. I would imagine that in market turmoil the trading divisions of the big banks make up for the deterioration in the other components of their business. No matter how you put it, I believe the big banks should have much more financial cushion and product portfolio flexibility to withstand a rate / credit deterioration related economic storm than their regional smaller peers.

Even the short term price action speaks loudly for some mean reversion. The beauty here is that depending on the direction one sees in the general market, playing one of the legs through options gives the benefit of capping losses and letting profits run.

Current positions: We remain super light on exposure with only a bit left in our REM and BBBY shorts.

Last week we got out of our long TLT trade as we were clearly wrong about a pause in the 20Y rates. Prior to FOMC we decreased our short book and we now have just a bit left in the long Oct put REM 27 - 24 ratio spread. We turned out to be dead right on the direction on this one, but were too quick to take off exposure. Our REM put ratio spreads is now comfortably within the strikes with a dividend of 62c coming in.

The BBBY trade is a tad lower than the lower strike of our long Nov 11- 7 put ratio spread but that is not a big concern as breakeven is at 3$.

Conclusion: Last week we started seeing that fragility from currencies and rates outside of the US that we have long been listening for. Likewise, risk assets in the US have suffered, but I believe a short-term capitulation might be just around the corner. All things line up a hundred points or so below in SPX which with a dollar in parabolic move and short term US rates near 4.5% would give a nice opportunity to catch the knife. Given the rise in volatility, patience, trade execution and mostly, risk management, are more important than ever.

Suggested reading:

This new section will include the work of other authors who I enjoy reading and help me build an informed framework for the markets.

The Macro Tourist - posts.themacrotourist.com - Kevin has a knack for identifying opportunities that others rarely see. What makes his approach unique is his macro view which can translate into actionable swing trading ideas.

FX Macro - fxmacro.info - A an excellent overview of what happened in the world of FX and Central banking.

The Morning Hark - harkster.substack.com - A great way to start your trading day. You have a summary of what happened in most major markets.