Everybody Has a Plan

“Everybody has a plan until they get punched in the face.” Who better to quote after a whopping 6% pullback in the S&P 500 since it peaked at a new-all time high on September 29, than Mike Tyson?

It never ceases to amaze me how a declining stock market can work people up into frenzy. I also find it fascinating how many people seem to be caught off guard by any type of downside in US equity markets.

The only people that seem to see this type of thing coming is the ammo and canned food crowd who are constantly calling for the end of the world and as soon as there is any type of dip in equity prices are the first to say “I told you so.”

If you are a regular reader of news or financial sites, the headlines alone would make you think you should be worried even if you’re necessarily inclined to get caught up in the media hype. Some of the headlines from last week:

“The Most Dangerous Market Since ‘08”

“If the Stock Market Plunges, 5 Things To Do.”

“After the VIX Super Spike, is the Worst Ahead”

“Some Things to Remember About Market Plunges”

“Markets: Into Uncharted Territory”

My favorite are the last two, “…Market Plunges,” “…Uncharted Territory,” really?  The S&P 500 (SPY) is off 6% over the last month and lost just over a 1% last week, does that really count as a plunge or uncharted territory?

SPY has traded at these levels on two other occasions this year alone, in both May and August. Before I get accused of being Jim Cramer and staunchly defending US equities and believing that every dip should be bought let me state clearly that I’m neither a bull or a bear, I’m agnostic in that respect; I don’t really care if markets go up or go down.

I’m not saying that the decline over the last month doesn’t have some signifigance or couldn’t be the beginning of something more dramatic. I just think it’s a waste of time to forecast whether this is the beginning of the end.

Stick to your process.

If your framework is solid, then it works whether markets are going up or down. Your process will tell you what markets to be involved in and which side of that market provides the best risk to reward characteristics.

I’m emphasizing that it's important not to get caught up in the headlines and rather, drill down and evaluate whats really happening.

Most investors are focused on whether now is the time to buy US equities or not. Being a global macro guy who focuses on what’s occurring at the margins, I think that’s the wrong question to ask. The right question to ask is, how has the last month changed financial markets moving forward, if at all?

 

UNITED STATES

The last time I did a drill down on US markets was in the September 29 issue of TWR. Here is what I said at the time as it relates to how investors were positioning themselves:

“The last time Investors began the year by positioning themselves for slower US growth.

This positioning continued well into Q3 as my “Slow US Growth” market index consistently and handily outperformed both the broader US equity markets as well as my “High US Growth” market index.

This relative and absolute outperformance continued until 1 month ago. During the month of September, the positioning in certain asset classes have begun to shift. While all 3 indices have declined since the beginning of September, slow growth assets have underperformed high growth assets by 130 basis points and the broader US equity market by 316 basis points.

This is a big shift from the first 8 months of the year when slow growth assets outperformed high growth assets by 1000 basis points and the broader US equity market by 500 basis points.

So, while investors' conclusions and markets jumped all over the place last week, I didn’t see a lot in the data to get worked up about.  In addition, markets are continuing to jockey back and forth without any real clear direction. Slow growth assets, once again, outperformed high growth assets by 175 bps and the SPY by 120 bps.

My takeaway from last week is that markets are still questioning how to be positioned for the final 3 months of 2014.”

So, what, if anything has changed over the last three weeks? There are 2 significant developments here in the US. The first is a shift in the positioning of investors as it relates to the prior month. The playbook of being LONG Slow Growth US assets and either SHORT or NEUTRAL on High Growth US assets that worked up until September has been working again.

My Slow US Growth market index has outperformed both the broader US equity markets (SPY) as well as my High US Growth market index. The Slow Growth Index is up 2.8% since September 29, while the High Growth Index is down 4.1% and the S&P 500 (SPY) is down 4.6%. That is an astounding divergence in performance over just three weeks and it says that investors are solidly positioned in the slow growth camp for the end of the year.

I can also tell you that from a technical perspective, the Slow Growth Index looks poised to explode higher while both the High Growth Index and the SPY have been damaged over the last 3 weeks and look suspect.

The other significant development over the last 3 weeks is the direction of the US dollar. As of the September 29 issue of TWR, the USD had just capped off a 5 month, 8.5% move by breaking out and closing above its 2009 downtrend line on the preceding Friday.

The US dollar peaked 5 days later and has since fallen 1.8%, closing this past Friday back below the 2009 downtrend line and below a critical price level at 85.50.  As a reminder, the main driver of the USD’s rally was the divergence in growth outlooks for the US versus the Eurozone and Japan had capital flowing into the US.

Since there hasn’t been a change in the fundamentals of either the Eurozone or Japan over the last three weeks, I have to believe that the recent weakness in the USD is related to investors re-evaluating the true growth prospects of the US.

No one is talking about the USD yet because a 1.7% decline after a huge run-up isn’t news worthy. And no one is discussing the various sectors of the US equity market, only the S&P 500. This is why it’s important to focus on what’s occurring at the margin, because few others are paying attention and by the time you hear about it on CNBC, its too late to provide you with an edge.

 

CHINA

Chinese equities (FXI) peaked in early September and had declined 8% as of September 29. In the three weeks since, FXI has declined an additional 2.5% and has been trading all around its 4 year downtrend line, spending more days below the line than above.

Fundamentals haven’t changed either, they still look suspect. The only driver of Chinese equities seems to be whether the markets believe the PBOC will step up with a broad based stimulus plan through rate cuts. Rumors can certainly push markets around but eventually reality sets in.

All of the PBOC’s actions over the last couple of months has pointed to taking their structural reform seriously and providing only targeted liquidity. The playbook for this market remains the same, SHORT if you’re so inclined, NEUTRAL if you’re not.

 

EUROPE

European equities (FEZ) peaked in mid June and had declined 9% as of the September 29 report. In the three weeks since, FEZ has declined an additional 8% on volume that is accelerating higher.

Fundamentals in the Eurozone have been deteriorating all year long and over the last couple of months the deterioration has continued and shows no signs of abating. As with China, the playbook for this market remains the same, SHORT if you’re so inclined, NEUTRAL if you’re not.

Let everyone else focus on a single, US-based index as a way to make investment decisions. Markets are global and inform one another, so stick to a global macro process that focuses on marginal changes in both asset classes as well as fundamentals. This will allow you to find profitable opportunities while everyone else is being punched in the face.