/ September 14 / Weekly Preview
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Monday:
N/A
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Tuesday:
NY Empire State Manufacturing Index (14.7 exp.)
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Wednesday:
Fed Interest Rate Decision
FOMC Economic Projections
Retail Sales MoM (0.9% exp.)
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Thursday:
Building Permits Prel (1.4M exp.)
Housing Starts (1.32M exp.)
Initial Jobless Claims (205K exp.)
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Friday:
N/A
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Monday:
N/A
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Tuesday:
N/A
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Wednesday:
Lennar Corporation
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Thursday:
N/A
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Friday:
N/A
On Thin Ice
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September seasonality is certainly living up to its reputation. The market retraced to its 50-DMA with the tape being reactive to the price of crude and the direction of yields. Furthermore, talks of slowing down the development of AI over the weekend are doing no favor to tech stocks, which look to start the week firmly on the back foot, pressured by both valuation concerns as well as yields.
Over the week, crude climbed roughly +9% across four sessions, pushing the 10-year Treasury yield up with it to just below 5%. Interest-rate-sensitive corners of the market weakened, and the S&P 500 fell -0.68% to finish the week at 7,666. Yet that modest headline masks a more significant story underneath.
Small Caps (IWM) declined -2.38%, lagging the Factors ETFs along with the Equally Weighted S&P 500 (RSP, -2.35%) and the Dow (DIA, -2.07%). The Nasdaq-100 slipped only -0.52%. When the median stock drops about three times more than the index, market leadership is narrowing rather than broadening. The margin of error for the leaders in this market is becoming narrow.
The big news was, of course, inflation data. Headline CPI increased 3.4% year-over-year and remains elevated, while core CPI held at 2.4%, slightly above the Fed’s target.
Producer prices told a hotter story: PPI rose 0.4% month-over-month and the annual rate accelerated to 5.4% from 4.8%. That headline figure, although above expectations, is likely to be revised downward with the benchmark adjustments at month-end.
The bulk of the move came from goods prices, which climbed 1.1%, driven in part by a 24% surge in diesel. Core producer prices also printed at 4.6%. Despite the negative bond market reaction, this appears driven by an oil-related shock rather than broad-based overheating in the economy. Since the start of the Iran conflict, the 10-year yield and oil (USO) have been moving in lockstep.
As such, we believe a Fed rate hike at this juncture would be misguided, at least going on the data that we have so far. Neither report was disastrous. But neither provides the Fed with a clear path to raising rates.
The market reaction remains consistent with a “rate scare”, as it was yield sensitive sectors which dragged the market lower all week. The fact that Gold, a non-yielding asset, also fell is telling.
The Fed meets on Tuesday and Wednesday. Markets still expect a 25-basis-point hike, with an 86% probability. Strong headline inflation and a crude oil surge aren’t the right conditions for monetary tightening, especially as the labor market is showing clear signs of softening.
The long end of the curve will tell the story after the decision. If oil keeps climbing and the 10-year breaks above 5%, valuations will come under much greater pressure. The narrow leadership that supported gains all summer will likely crack first, a not unusual outcome for the month of September as the midterm election cycle approaches.
Technically speaking, the bulls managed to save face last week. After a somewhat sharp sell-off on Thursday, Friday’s rebound took the market above the key 50-DMA level. With corporate buybacks sidelined, interest rates spiking and oil surging, this is quite a remarkable achievement. Now the question becomes: will support hold?
While the first test passed, momentum slowed and downside pressure remains persistent. Both the weekly and the daily MACD indicators are negative, while RSI is neutral. GEX is positive, while Dark Pools venues showed accumulation on the week.
From our vantage point, this is shaping up to be a challenging week yet again, with Friday’s OPEX event being the fulcrum. If the 50-DMA / M-Trend level fails to hold, a larger downside gap opens up, with the next level at $704 (S1 & 200-DMA).
A weekly close above $757 on SPY would indicate buyers have retaken control. A weekly close below $757 would mean the 50‑day moving average has failed and the market is seeking deeper support. Readings between those levels are inconclusive. The two major catalysts this week are large enough to push the market one way or the other.
The first major event is the FOMC decision, of course. The decision, updated projections, and Warsh’s press conference all happen on Wednesday afternoon. Markets are pricing in a rate increase, but this past week’s data, as mentioned earlier, makes the choice more difficult.
A central bank should be reluctant to raise rates when headline inflation is 3.4% largely because of a temporary crude-oil spike, so Wednesday’s more important story may be who dissented rather than whether rates were raised. Investors might also be asking the “one and done” question (if the Fed is planning to raise more than once).
The second catalyst of the week is purely mechanical.
Friday marks the quarterly options and futures expiration, commonly called “quad-witching.” This one is poised to be the largest on record, reflecting the recent surge in options activity. Historically, massive expirations often pin prices near major strikes, then move sharply once those levels are cleared.
Going into this week, investor sentiment is decidedly negative, with our proprietary metric now reading “Extreme Fear”.
Our read so far is that the market is priced for a hike. If Warsh actually delivers a hike, the rate-sensitive trade may move in the other direction than broadly expected. In other words, a rate hike might turn out to be a relief for bond traders after all.
The true vulnerability for the bearish thesis is sentiment. S&P 500 earnings are compounding at about 30%, yet investors are behaving like a recession is around the corner.
Nasdaq-100 short interest has risen roughly 35% since June. A sharp third-quarter de-grossing has pushed fundamental long/short net leverage to the 6th percentile over the past year, gross tech exposure sits near the 43rd percentile, and approximately $163 billion in cash remains on the sidelines waiting for a pullback that hasn’t materialized.
The rally that we’ve had is earnings led, not multiple led, and this single fact separates today’s market from 2000. The question is not if earnings growth exists, but to what degree is it sustainable into the future and what’s the correct discount to be applied to future cash flows. The average trailing 12 month EPS growth for the market’s largest stocks is a whopping 63%.
Strong earnings, low exposure, high short interest, and a pile of idle cash create the ideal setup for a “pain trade” that pushes prices higher and forces the underinvested to chase. This background keeps us long into ATH values, despite an inherent discomfort in owning these positions (investors always get paid for “discomfort’ in the end).
The problem with the clean bull story are valuations. With the exception of the PEG ratio (currently subdued due to very high gross margins), all other multiples are pushing historic highs (chart below shows price / sales). As with many series in finance, valuations tend to mean-revert. Such a compression would collapse prices by ~18%, and that’s only assuming the correction stops at the mean (though many times the overshoot is larger).
There are probably 2 ways this will resolve:
AI-related capital expenditures translate into sustained returns alongside stable record margins; this would allow earnings to catch up with current prices, compress multiples and the bull market can continue;
Capex depreciation begins to drag on the income statement, AI demand slows significantly, margins revert to normal, and profits decline back toward their prior trend;
Case 2 would likely result in a bear market, as these kind of corrections do not resolve in a sideways manner.
Our Trading Strategy (Sigma Portfolio)
For now, no immediate action is required on our side, as we have already lightened up on risk exposure and raised cash last week, in anticipation of volatility and weakness.
While the near term evidence leans bearish, we are aware that sentiment is already dreadful. Our concerns are more geared toward the longer term sustainability of the bullish advance and the high bar that companies now need to pass in order to impress investors.
We would also not be fans of a rate hike in the current environment. A “one and done” might be fine, but a full-on campaign could constitute a policy error and snuff out the labor market, just as it is slowing down by itself.
In any case, once Friday’s OPEX event passes, the calendar tends to lean much more bullish so it’s likely we will get more constructive once October starts.
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