Happy Friday to all.
I think today is a good day to look at what happened over the course of the last month, what is happening today, and potential future outcomes from here.
It really got kicked off with smalls caps when they broke out to new all-time highs back in early August, before setting a top on August 31st.
Small Cap to Yields
The weakness in small caps came at an interesting time as the 10 year yield began to rise drastically. The chart below shows in green the small cap index and the US 10 year yield in blue.
Small Cap Debt
This relationship becomes interesting as you can see from our quarterly Periscope presentation that small caps carry a lot of debt. Not only do they carry an aggregate 5X net debt to EBITDA, but much of that debt is floating. So rising rates are a concern to this area of the market.
This weakness in small caps and also micro caps then bled into the S&P 500 which peaked 1 month after small caps.
The Nasdaq was also part of the mess early on as it ended up peaking at the the same time as small caps. The difference however was that the Nasdaq staged a re-test of its former highs on October 1st and failed. So at this point we were getting false breakouts to the upside in most markets, while also losing leadership.
Risk on / Risk off
Since the start of the month we have seen all of our risk on / risk off indicators point to a heavy risk off sentiment. In our weekly chart book we look at stocks under-performing bonds, growth stocks under-performing value, volatility spiking, and small caps under-performing.
This takes us back to history, as here is a chart we have been sending out. This is the 4th time we have seen a 5% drop or more in stocks within the October period. Historically these drawdowns take some time to bottom out before a new cycle higher emerges. We think this time will look more like the green and white (1977,1978) as opposed to the 1987 or 2008 periods. If that holds, then a bottom could be put in within a couple weeks and new highs emerge in a couple months.
Credit Default Swaps
Generally speaking, during times of real economic stress, we tend to see many factors blow out. One of those factors tends to be credit default swaps as investors begin buying credit protections. We simply are not seeing that today.
Sentiment is a key factor to bottom fishing. We are starting to see two metrics showing that we may be closer to a bottom then a top. On the left is the VIX term premium. We are essentially looking at the spread between short term vix and long term vix pricing. As this metric elevates towards 1.1 and above, it signals short term fear is extreme. The right side is the AAII investor sentiment reading which came in yesterday and showed a big rise in bearish views. This metric is survey based and is signaling elevated levels of bearishness among investors.
Putting it all together
While there is more data to share to highlight my views, it may be prudent to stop here. The last chart shows a near-term view of the S&P and Small Caps. Both are trading down to their February lows which are -2% away for small caps and -4% sway for the S&P. That seems like a logical place for markets to test as it goes through this panic digestion period. We will continue to monitor fundamental data points such as CDS to get a sense if real pressures are coming into the economy.
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Disclaimer: This is not a recommendation for purchase or sale of any securities. Avory is a not a shareholder of either company, but this can change at anytime.
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