If we learned anything on Friday, it’s that there might be arsenic hiding in the J&J baby shampoo.
I’m just kidding.
As one reader politely pointed out, the reaction to the asbestos/Baby Powder story was probably overdone – at least as it relates to J&J’s share price.
What we actually learned on Friday is that the combination of i) a decelerating Chinese economy, ii) the indeterminacy inherent in the juxtaposition between ostensibly positive trade news and the diplomatic tension between Ottawa and Beijing, and iii) the incessant flow of ominous legal headlines for Donald Trump, is serving to perpetuate the “sell the rip” mentality that this year supplanted “buy the dip” as the dominant market mode.
Upside is capped as trade truce headline-induced gains are quickly monetized, while downside moves are limited (and that assumes you can describe a 2% daily drawdown as “limited”) by the simple fact that after the massive de-grossing/de-netting/de-beta’ing that unfolded during October, there’s not that much exposure left for the fundamental/discretionary crowd to pare.
This dynamic is behind the ongoing “chop” and it’s limiting the ability of the market to move sustainably above key re-risking levels for systematic strats. Or at least that’s what Nomura’s Charlie McElligott believes.
McElligott this week called for an upside squeeze predicated on the notion that the Fed pivot would cap dollar upside and thereby help boost inflation expectations and commodities (risk asset +) against a backdrop where underexposed investors would have to buy into any upside to avoid being left behind.
That call was on the verge of being borne out on multiple occasions this week (which is something I think some readers don’t fully appreciate – there were several times this week when Charlie’s call was this close to being vindicated, only to see things tip decisively in the other direction thanks to, among other things, Trump’s absurd Oval Office meltdown). Ultimately, though, things ended on a sour note with Friday’s selloff, which, if you round up a bit, was the 14th day of 2018 during which the S&P has fallen 2% or more.
“In what has become simply yet another expression of macro regime change from QE to QT, the multi-year US Equities conditioning to ‘buy the dips’ has evolved into ‘sell the rips,'” McElligott wrote on Friday morning. As alluded to above, some of this appears to be related to the active community having “shut it down”.
Charlie goes on to put this in the context of the massive exodus from U.S. equity funds in the week through Wednesday. According to EPFR, U.S. equity funds lost some $28 billion during the week, the second-largest weekly outflow on record.
“The Equities performance environment (the violence of the 2.5-month drawdown and the impact it has had on sentiment) in addition to the simple proximity into year-end is effectively rendering much of the active/discretionary trading universe shut, reduced to watching and not trading the gappy and illiquid moves”, he writes, on the way to documenting the exodus noted above as follows:
Certainly then this Equities de-risking / outflow corroborates with this week’s EPFR fund flows data, showing an astounding -$27.7B outflow for US Equities (Institutional, Retail, Active and Passive combined), the second worst weekly redemption of the past 1Y period.
And so, as retail investors bail and with the active community in suspended animation into year-end, rallies cannot be sustained.
“It is this de-risking flow which looks to be the primary reason for the inability to trigger our estimated systematic CTA ‘covering short / flip long’ flows in SPX (where the 1Y bucket would turn from short and pivot outright long), as the overall allocation has not changed due to the S&P’s inability to close above the required 2665 buying-level to force the very large notional buying”, McElligott says, flatly.
That said, the dynamic could change at the turn of the year, based on the following factors which Charlie reiterated on Friday morning:
- Global central banks “dovish pivot” turning more aggressive and looking increasingly coordinated—especially with the increasing evidence of “Fed Pause”
- Fundamental managers no longer shackled with the calendar and can reassess the case for adding to high conviction names at more attractive valuations
- The seasonal strength phenomenon for SPX dating back to 1994, with SPX as the global Equities index leader, +1.6% median change at a 58% hit-rate
- The SPX sector seasonal for January would too benefit consensual fund positioning, as Tech (+1.5%) and Healthcare (+1.0%) are #’s 1 and 3 best median sector returns back to ’94, which could further induce “re-grossing” behavior into the market, especially against favorite / consensual shorts in cyclical sectors generally underperforming on the seasonal look back as well:
While it’s probably not accurate to say that Charlie is “giving up” on 2018, the overarching point here is that some folks apparently have either by choice or by “shoulder tap”.
And in the absence of an unexpected dissipation in the increasingly manic pace of the geopolitical headline deluge, the outlook for a Santa rally looks increasingly Bah humbug-ish.