The Weekly Risk Radar is designed to monitor key factors impacting the liquidity, business, and market cycles.
For the week ending July 31, the S&P 500 Index closed +1.75% and the Bloomberg Barclays U.S. Aggregate Bond Index finished +0.23%. 2020 year-to-date performance by asset class is shown below.
Here are the top 3 risk takeaways
What’s trending? Stocks were up in July but consolidated in the last two weeks. SPX finished July with an important technical “buy” signal; its first since March. All of our trend models are bullish heading into August. The VIX Index (24) and SPX implied volatility (12%) remain elevated as markets try to digest earnings, fiscal stimulus, and vaccines.
Soggy dollar. The dollar has been in a major downtrend since early March. This reflects deteriorating U.S. fiscal conditions, massive monetization of Treasury debt by the Federal Reserve Bank, and growing U.S. political uncertainty. Superior growth prospects in Asia and Europe may also be contributing to capital flows away from USD assets. The dollar index (DXY) closed July at 93.5 (-3% ytd). There is little technical support until 90, implying further downside. Speculative short positions in the dollar are at a 3-standard deviation level, suggesting the short-dollar trade is overcrowded. Any countertrend rally could be associated with a new “risk off’ period like we saw in March. Still, our best guess is the dollar may decline through the November election.
Earnings blast. This week we learned the U.S. economy declined in the second quarter by 9.5% y/y, the largest y/y quarterly decline on record. Market reaction to this old news was back in March. Since April, the market has been reacting to the recovery. If our base scenario of a “W”-shaped recovery is correct, the super-sonic recovery since April should give way to slower (decelerating) economic activity. We are closely watching jobs and earnings data to confirm or reject our “W” hypothesis.
With 62% of S&P constituents reporting second quarter earnings, sales have declined 12% and EPS have declined 11%. Some sectors’ earnings were worse (energy) than others (discretionary).
Why is the stock market up 2% when earnings are down almost 11%? Maybe it’s because future earnings growth is about to accelerate. Maybe it’s because the discount rate used to value corporate cash flows is close to zero. Maybe central bank liquidity trumps fundamentals. Or, maybe the stock market has it wrong.
We have no ability to predict when the decoupling of price and fundamentals will end, but we are certain it will. Some day. It will likely be driven by decelerating or deteriorating liquidity conditions. Now is the time for investors to prepare for such inevitabilities.
Cycle analysis update for the week ending July 31
Liquidity cycle (100% of factors are favorable). Global liquidity is accelerating with global money supply growing 20% on a 6-month annualized basis. Financial conditions are now improving faster outside the U.S., especially in Asia. Markets are expecting another $1.5 trillion stimulus package from Congress and more QE to monetize the debt.
Business cycle (47% of factors are favorable). A flattening yield curve, negative Leading Economic Indicators, and a deteriorating labor market point to an impending down-leg of our “W”-shaped base case. Higher inflation swap spreads and higher highs in the gold/treasury ratio point to accelerating inflation expectations. This confirms the prevailing regime is “stagflationary”.
Market cycle (56% of factors are favorable). Positive implied volatility for the S&P 500 and a declining VIX regime support current positioning. Credit spreads remain tight as investors follow the Fed’s lead in buying corporate paper. Under normal conditions, credit market stress would lead an equity market correction. The Fed is ensuring these will not be normal times. Market sentiment is mixed. The CNN Fear/Greed Index is too bullish. However, 48% of AAII survey participants say they’re bearish.
Conclusion:
Model portfolios are positioned for a “stagflationary” regime and tactical risk budgets are 95% of strategic targets.
Chart below shows the unemployment rate in the U.S. (blue) and Western Europe (red).
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DISCLOSURE: Past performance is no guarantee of future results. This material has been prepared or is distributed solely for informational purposes only and is not a solicitation or an offer to buy any security or instrument or to participate in any trading strategy. Any opinions, recommendations, and assumptions included in this presentation are based upon current market conditions, reflect our judgment as of the date of this presentation, and are subject to change. All investments involve risk including the loss of principal. All material presented is compiled from sources believed to be reliable, but accuracy cannot be guaranteed and Risk Report and Tomah Management, LLC make no representation as to its accuracy or completeness. Securities highlighted or discussed in this communication are mentioned for illustrative purposes only and are not necessarily a recommendation for these securities.