SPY and The 'One-Arm' Stress Test

As I was driving down the road the other day; I saw a gentleman driving with a box spring and mattress lassoed on the top of his SUV. He had his driver’s side window down and he was holding a piece of one corner of the mattress with his left hand while driving with his right. This type of scene isn’t unique. 

We’ve all seen this play out. However typical this is, it occurred to me, “What did he think he was going to be able to do with one hand if that king-size mattress and box spring started to shift on the roof or if the bungee cords weren’t quite as well secured as he thought?” 

I don’t care if you have pythons for arms, there is absolutely no way you are going to be able to arrest the duos' movement with your left hand if they begin to shift. Yet, the instinct for many of us is to put our hand on some portion of the items on the roof, believing that the presence of our left hand somehow makes the items more secure.

This is an illusion of control, not actual control. I find that many investors manage their investments using a similar belief system; believing they control a lot more than they actually do.

 

Do The Work Before The Drive

 

I’m not saying that you should just throw a mattress on the car and start driving. Just like I’m not saying you should just put a trade on, risk capital and stop paying attention. Quite the opposite. 

Once you put the mattress on your car, you should do everything you can to secure the mattress before you start driving. You should even “stress test” the mattress and give it a few tugs to see if you can dislodge it. 

In a similar way, before you put a trade on, you should “stress test” it. That’s why I give you a very precise risk price for each trade idea in TWR. That way you can determine how much capital you want to risk on that idea given your circumstances and risk tolerance. 

This type of testing gives you the confidence to drive the whole way to your destination without feeling the need to keep your left arm on the mattress the entire time. You already know, before the journey starts, what the worst-case scenario is and exactly what is at risk if for some reason the mattress begins to fall off the car. Now, you just need to check in periodically to make sure that everything on the roof is just as it was when you first started to drive.

 

With that in mind, let’s roll the window down, touch the corner of the mattress with our left hand and make sure our SHORT US equities trade idea hasn’t shifted on us.

 

Stress Testing Our SPY Short

 

It has been 4 weeks since we initiated our SHORT trade idea in SPY and there has been a deluge of Fed commentary and economic data points to wade through, coupled with a 2% rally in SPY, which has put our trade idea 61 basis points in the hole.

I thought this week would be a good time to step back and evaluate the key developments over the last month to see if it’s time to close out our SHORT and possibly change my market bias for US equities.

The first place we start is what I call the fundamental gravity of a particular market. Are the underlying fundamentals of the market bullish and exerting an upward force on the market or bearish and exerting a downward force?

We could spend a ton of time dissecting every data point that has come down the pike in the last month but the reality is that the only data point that matters when it comes to the growth trajectory in the US is GDP.

Luckily for us, tracking GDP in real time gets easier with each passing week. We now have 2 tools that are readily accessible. The Atlanta Fed was the first to offer us a tool called GDPNow. 

And last week it was announced that the NY Fed has followed suit with its own GDP tracking tool called Nowcast. Incorporate one or both of these tools into your decision making process about US markets. 

When we initiated our SHORT trade idea back on March 17, the Atlanta GDPNow was forecasting a Q1 growth rate of 1.9%. This was down from a 2.7% estimated growth rate that was released on February 12. 

When we initiated the SHORT trade idea, fundamental gravity was definitely on our side. In the weeks since we’ve initiated our trade idea, GDPNow has come out with 10 new updates and the growth rate has fallen from 1.9% down to just 0.3% as of April 13. The fundamental gravity is evident and remains decidedly bearish.

The next aspect of the market that we need to evaluate is the quantitative. “Quantitative” is a catch-all for price action, volatility, volume, interactions with ALPINE and ABYSS lines as well other dynamics of a particular market. 

From this perspective, not a great deal has changed in SPY since we took our position. Yes, there has been a 2% rally but this rally hasn’t accomplished much. The rally hasn’t caused SPY to punch through critical resistance or given US equity bulls a ton of confidence in their positioning. In fact, most of the 2% rally occurred just last week. 

SPY is being pulled higher by other risk assets and not because there is any compelling catalyst here in the US. Obviously the most critical line of resistance, which still stands, is the all-time high from back in July 2015 at $209.75. 

The final aspect of SPY to evaluate is the behavioral aspect. How have investors, large and small, changed their positioning in the last couple of months?

When we took the position a month ago, SPY was rallying despite the fact that most investors were net sellers of US equities in favor of buying bonds. That trend is still firmly intact. 

As of last week, retail investors, hedge funds and other institutional investors have been net sellers of US equities for 11 consecutive weeks. The selling has been broad-based an indiscriminate.

Investors are selling large caps, mid caps and small caps. In terms of S&P stocks, the selling is occurring across 8 of the 10 S&P sectors. The largest outflows are occurring in the financials and consumer discretionary stocks. There was a small amount of buying in telecom and industrial stocks. This is an important point because financials and discretionary stocks make up 30% of the S&P whereas the telecom and industrials make up just over 12%. It’s only a matter of time before this selling catches up with the price action of the S&P and SPY.

Based on my current assessment of those 3 aspects of the US equity market, I’m not deterred by our slight loss. In fact, I’m even more resolute in believing the S&P 500 and specifically SPY, is more likely to see $194 before it sees a close above $210. The probabilities are skewed to the downside from here and given our entry price of $204.63, there is at least 2 times more reward than risk in our trade.

Don’t fool yourself into thinking that you have more control than you do. Markets are mostly random and filled with noise. There are only two things you can control at all times. First, make sure that you have an investment process in place that consistently puts you in trade ideas where the outcome is skewed in your favor and the reward heavily outweighs the risk. Second and most importantly, make sure that you follow that process, no matter what.