Published January 27th 2022

Daily Brief - Is the selloff done?

Stocks took a precipitous tumble last week, with SPX dropping 11%+ from the peak. Crypto followed suit making new lows. Bonds were falling too. We also witnessed human sacrifice, dogs and cats living together and general mass hysteria.

The retracement was mostly felt in meme/momentum stocks, whereas energy stocks like XOM were making highs led by the rally in crude.

Certain data points can help put this drawdown in perspective. Let’s go through them:

Speculative positioning was extreme: > 25% Net Positioning

Only 3 times in the last decade we had seen speculative traders so crowded on the long side.

Look at the chart below: we had seen so much speculation only in March 2013 and October 2018. In the former case the market kept rallying led by QE, in the second case it posted a -17% performance in the famous Q4’18 mini bear.

As the market dropped last week, these spec longs reloaded their positions - they bought the drawdown. It is likely this compounded the further fall this week.

S&P 500 Net Futures Positioning
Speculative positioning in SPX was extreme

Valuations vs. bonds were extreme: <3% ERP

The equity risk premium is a simple concept - it’s the relative valuation of equities compared to bonds.

In the chart below, low = expensive and high = cheap. When the Equity Risk Premium is below 3% as right before the drawdown, equities are expensive when compared to bonds.

Since bonds fell hard in the last weeks, whatever support they offered to equities disappeared altogether.

S&P 500 Equity Risk Premium (forward)
SPX’s Equity Risk Premium was extreme

Inflation was extreme: 7% CPI

Well you know about this already - CPI reached its all-time high bringing us back to the 80’s. This invigorated the Fed’s hawkish bent and led to calls for 4 hikes this year.

S&P 500 Consumer Price Index Y:Y
CPI joined the 80’s nostalgia bandwagon

So what next? Are we at the bottom?

The obvious question is whether we are at the beginning of a bear market, or if this is an excellent entry point to play for a rebound.

In the short term we can list 5 reasons to foresee a rebound:

  • Positioning is marginally cleaner: Speculative positioning retraced from the peaks (but it could be much lower)
  • Valuations are marginally better: Equity Risk Premium is higher (= cheaper)
  • Bonds have priced CPI: US 10y rates moved plenty, thus pricing in well the 4 hikes expected this year
  • Oil has stopped rising: Oil seems to have finally stopped its rise
  • The bottom-up picture is constructive: the TOGGLE Leading indicator is in bullish territory - you can find it in the next Friday Daily Brief. The long-term forecast is much harder, and it will be part of a different daily brief.

If I believe in a rebound, how should I trade it safely?

See tomorrow’s Daily Brief: “How to catch a falling knife”.

Daily Brief - Is the selloff done?

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