Lance Roberts

As noted last week , the correction continued. As noted:

“While the correction has been quite normal, Friday’s break of the 50-DMA suggests the correctional process continues. As we discussed in June and July, a 5-10% correction was likely, and we are in the middle of that process. The market is getting decently oversold, and we are likely seeing a short-term exhaustion of sellers. Notably, the market held the 100-DMA on Friday, which was critical support during the April correction. With markets oversold, we would be unsurprised to see a reflexive rally next week. Use rallies to rebalance risk and reduce exposure as needed.”

While we did get that reflexive rally, it came after an unexpected event shocked markets into a deep selloff on Monday. As we said in the “Yen Carry Trade:”

“Consider that ‘yen carry traders’ have leveraged highly volatile risk assets like cryptocurrencies, small-cap stocks, mega-cap stocks, and even the Japanese market. The carry trade works well as long as the Japanese Yen does not markedly appreciate, forcing a liquidation of the market leverage.

The problem is that the Yen has appreciated more than 15% in the last few weeks. As the Yen appreciates, the Japanese banks demand margin calls (i.e., the catalyst). When that occurs, the hedge funds, pension funds, insurance companies, or investors using the ‘Yen carry trade’ must either put up more collateral or sell the leveraged assets. That reversal and forced liquidation created a vicious spiral by pushing the Yen higher and risk assets lower.”

Events like these tend to be temporary and rarely devolve into more extreme market corrections. However, there is always that risk, so we suggest rebalancing portfolio risk as needed. While the reflexive rally into Friday erased Monday’s market plunge, there is still likely sufficient risk to warrant a more cautious approach over the next month or so.

In this week’s missive, we will discuss the recent events in more detail. What caused it, and what will likely happen next?

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Why Did The Market Crash? The events on Monday sent investors running for cover. As discussed on the Real Investment Show , headline events like the economy, employment, debt, deficits, or geopolitical conflict are quickly evaluated and hedged by market participants. Therefore, the “known” events rarely cause sharp market declines as buyers and sellers compensate for those risks.

However, some events, like the spike in the Yen that collapsed the “Yen Carry Trade,” can take market participants by surprise. These “unexpected, exogenous events” lead to a “shoot first, ask questions later” response from market participants, which acts as the “catalyst” that unwinds market complacency. As noted in that linked article, the ingredients of a mean-reverting event were present; all that was needed was a trigger.

“If I gave you a bunch of ingredients such as nitrogen, glycerol, sand, and shell, you would probably stick them in the garbage and think nothing of it. They are innocuous ingredients and pose little real danger by themselves. However, you make dynamite using a process to combine and bind them. However, even dynamite is safe as long as it is stored properly. Only when dynamite comes into contact with the appropriate catalyst does it become a problem.

Mean reverting events,’ bear markets, and financial crises result from a combined set of ingredients that a catalyst ignites. Like dynamite, the individual ingredients are relatively harmless but dangerous when combined.

Leverage + Valuations + Psychology + Ownership + Momentum = “Mean Reverting Event”

Importantly, this particular formula remains supportive of higher asset prices in the short term. Of course, the more prices rise, the more optimistic investors become. While the combination of ingredients is dangerous, they remain “inert” until exposed to the right catalyst.

That catalyst is always an unexpected, exogenous event that triggers a rush for the exits. “

To understand why there was a sudden rush for the exits, we must realize that “Buyers Live Lower.”

“The market price is always a function of buyers and sellers negotiating to make a transaction. While there is always a buyer for every seller, the question is always, ‘What price?’

During a strongly trending bull market, few people are willing to sell, so buyers must keep bidding up prices to attract a seller to make a transaction. As long as this remains the case and exuberance exceeds logic, buyers will continue to pay higher prices to get into the positions they want to own. Such is the very definition of the ‘greater fool’ theory. However, at some point, for whatever reason, this dynamic will change. Buyers become more scarce as they refuse to pay a higher price. When sellers realize the change, there will be a rush to sell to a diminishing pool of buyers. Eventually, sellers begin to ‘panic sell’ as buyers evaporate and prices plunge.

Sellers live higher. Buyers live lower. What causes that change? No one knows.”

In this particular event, the spike in the Japanese Yen led to effective “margin calls” on the leverage being applied through the carry trade. Given that this massive $20 Trillion carry trade is used broadly across Wall Street hedge funds, everyone must sell simultaneously, with potential buyers being very scarce. Notably, there were indeed buyers in the market on Monday. They were just 3% lower than when the market closed on Friday.

The next question is whether the “selling” is over.

A History Of Event Corrections When a market crashes, investor fear increases. Two psychological responses from investors tend to precede and exacerbate a market crash. The “herding effect” and “loss aversion.”

These two behaviors tend to function together, compounding investor mistakes over time. As markets rise, individuals are optimistic the current price trend will continue indefinitely. The longer the rising trend lasts, the more ingrained that optimistic belief becomes until the last of “holdouts” finally “buys in” as the financial markets evolve into a “euphoric state.”

As the markets decline or during a market crash, people realize that “this decline” could be more than a “buy-the-dip ” opportunity. As losses mount, loss anxiety increases until individuals seek to “avert further loss” by selling.

This behavior often results in investors selling near market lows. The charts below, courtesy of @themarketear, show previous market crashes that resulted in swift, sharp declines caused by unexpected exogenous events. While the current market environment and recent market crash differ from these earlier periods, we will likely find similar psychological responses in the weeks ahead.

The crash of 1987 resulted from the failure of “portfolio insurance.” The decline in 2011 was due to an earthquake that sparked a tsunami, flooding Japan and shuttering essential exports. In late 2015, the market moved sharply lower as Janet Yellen discussed tapering monetary support. The market crash in 2018 resulted from an unexpected statement by the Federal Reserve that interest rates were “nowhere near the neutral rate,” suggesting further rate increases.

The recent market crash has many of the same hallmarks as these past events:

An unexpected, exogenous event causes sellers to swamp buyers in a “rush for the exits.”

The market price moves sharply lower to find “buyers” at substantially lower prices.

The market bounces as buyers step in to buy at reduced prices.

The initial market rally fails, prices revert to previous lows, and investors’ sentiment becomes bearish.

Buyers return to meet sellers at lower prices, ending the corrective period.

What Did They Know While the “Yen Carry Trade” shock spooked markets on Monday, the correction was already underway as hedge funds were reducing exposure. As we noted on July 27th :

“Hedge fund exposure to tech dropped sharply during the past two months. At the same time, hedge funds remained highly exposed to all other sectors, and the violent selling in the ‘Mag 7’ sparked a burst in volatility, which prompted broader selling across the board. It was one of the sharpest rotations over the last decade.”

As noted, it was one of the largest de-grossing of long exposures since 2022.

While retail investors were unaware of the stress building, hedge funds were already working their way out of positioning. Unfortunately, hedge funds weren’t able to completely reverse their positioning as the explosion in the Yen required a rapid uncontrolled liquidation of assets across portfolios. Like the events noted above, there was a rapid “rush for the exits, ” sending stock prices lower and volatility higher.

Notably, Goldman Sachs and JPM Morgan noted that much of the pressure from the Yen carry trade has been resolved. According to Goldman, investors are net long the Yen as of this week, which implies that the carry trade has been primarily unwound.

We agree with their conclusion, as hedge funds are now re-grossing their books.

While we expect to see a further bounce in August simply because sellers have exhausted themselves, we are likely not done with the recent volatility.

More Volatility Before We Are Done The market rally from Monday’s lows is unsurprising. However, as noted in our recent commentary:

“With the major markets deeply oversold short-term and sentiment becoming more bearish, it is quite likely the market will bounce over the next several days to a few weeks. However, as shown below, many investors were caught by the swiftness of the sell-off across all markets. These “trapped longs” will look for a rally to sell into, particularly in the more speculative areas of the market like small and mid-cap stocks, cryptocurrencies, and meme-stocks.

As shown, as of yesterday, the S&P 500 traded well into three (3) standard deviations below the 50-DMA. These more extreme and sharp declines are often met with buyers looking to ‘buy the dip.’ However, with the market ‘gapping down’ over the last couple of sessions, many of these ‘trapped longs’ will look to exit closer to the 100-DMA. Following that, I would be unsurprised to see the market retest recent lows or decline further over the next month towards the 200-DMA. “

The good news is that markets rallied choppily into the weekend. It seems likely that the forced selling from the spike in Yen may be behind us for the moment. Technically, the markets remain oversold enough for a further rally, and with the market clearing the 100-DMA on Friday, the 20- and 50-DMA remain the next formidable resistance levels.

Furthermore, some significant events over the next 90 days could re-introduce additional volatility to the market. The latest article from WSJ’s Timiraos (here) suggests that further data weakening is necessary to push the Fed from a 25bps to a 50bps cut in September. That could set up Jackson Hole to deliver a hawkish surprise, as markets are pricing in ~44bps of cuts at the September meeting. If the Fed were to push back on going 50bps, markets would likely respond negatively.

August and September are typically weaker during election years, and given the policy uncertainty, negative seasonality can extend into October. Combine that with heightened geopolitical risks, and it is tough to see material re-risking that takes the market higher in the near term.

Therefore, a more cautious approach to portfolios over the next 90 days would seem prudent. If this recent market crash plays out like our examples above, a retest of recent lows or even the 200-DMA, as noted, seems the most logical.

How We Are Trading It There is no magic formula for managing portfolios; everyone does it differently. However, as we often discuss, a few practices can significantly reduce the risk of an unexpected market correction.

As noted, there is an apparent crack in the market that suggests investors should take some portfolio actions. While we have discussed these simplistic rules over the last several weeks, it is time to rebalance risk if you have an allocation to equities.

Tighten up stop-loss levels to current support levels for each position.

Hedge portfolios against major market declines.

Take profits in positions that have been big winners.

Sell laggards and losers.

Raise cash and rebalance portfolios to target weightings.

Notice that nothing in there says, “Sell everything and go to cash.”

Remember, our job as investors is pretty simple – protect our investment capital from short-term destruction so we can play the long-term investment game. Here are our thoughts on this.

Capital preservation is always the primary objective. If you lose your capital, you are out of the game.

Seek a rate of return sufficient to keep pace with the inflation rate. Don’t focus on beating the market.

Keep expectations based on realistic objectives. (The market does not compound at 8%, 6% or 4%)

Higher rates of return require an exponential increase in the underlying risk profile. This tends to never work out well.

You can replace lost capital – but you can’t replace lost time. Time is a precious commodity that you cannot afford to waste.

Portfolios are time-frame specific. If you have a 5-year retirement horizon but build a portfolio with a 20-year time horizon (taking on more risk), the results will likely be disastrous .

Keep moves small for now. As the markets confirm their next direction, we can continue adjusting accordingly.

Have a great week.

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Bull Bear Report Market Statistics & Screens SimpleVisor Top & Bottom Performers By Sector S&P 500 Weekly Tear Sheet Relative Performance Analysis Last week, we said we suspected the current correction process was incomplete. On Monday, the sharp drop in the markets confirmed that suspicion. We had recommended reducing exposure to markets, which served well during the decline on Monday. While markets have rallied back somewhat, these reflexive rallies from deep oversold conditions should be used to rebalance risk. The current corrective process is likely incomplete; another test of recent lows remains possible over the next few weeks. Remain cautious for now.

Technical Composite The technical overbought/sold gauge comprises several price indicators (R.S.I., Williams %R, etc.), measured using “weekly” closing price data. Readings above “80” are considered overbought, and below “20” are oversold. The market peaks when those readings are 80 or above, suggesting prudent profit-taking and risk management. The best buying opportunities exist when those readings are 20 or below.

The current reading is 58.21 out of a possible 100.

Portfolio Positioning “Fear / Greed” Gauge The “Fear/Greed” gauge is how individual and professional investors are “positioning” themselves in the market based on their equity exposure. From a contrarian position, the higher the allocation to equities, the more likely the market is closer to a correction than not. The gauge uses weekly closing data.

NOTE: The Fear/Greed Index measures risk from 0 to 100. It is a rarity that it reaches levels above 90. The current reading is 58.39 out of a possible 100.

Relative Sector Analysis Most Oversold Sector Analysis Sector Model Analysis & Risk Ranges How To Read This Table

The table compares the relative performance of each sector and market to the S&P 500 index.

“MA XVER” (Moving Average Crossover) is determined by the short-term weekly moving average crossing positively or negatively with the long-term weekly moving average.

The risk range is a function of the month-end closing price and the “beta” of the sector or market. (Ranges reset on the 1st of each month)

The table shows the price deviation above and below the weekly moving averages.

The previous overbought and extended conditions that existed three weeks ago have been reversed. That sets the market up for a decent rotational rally in the days ahead. Look for a rotation into decently oversold growth sectors with significant declines. However, as noted above, use rallies to rebalance exposures, as the current correction process is likely incomplete.

Weekly SimpleVisor Stock Screens We provide three stock screens each week from SimpleVisor .

This week, we are searching for the Top 20:

Relative Strength Stocks

Momentum Stocks

Fundamental & Technical Strength W/ Dividends

(Click Images To Enlarge)

RSI Screen Momentum Screen Fundamental & Technical Screen SimpleVisor Portfolio Changes We post all of our portfolio changes as they occur at SimpleVisor:

Aug 8th “This morning, we tweaked the equity model. We are taking more profits in Stanley Black & Decker (SWK), bringing it down from 3% to 2% in the portfolio. However, we are increasing Costco (COST) from 4% to 4.5% as the stock is oversold and turning up on a MACD buy signal. Both trades are based on technical setups.”

Equity Model

Reduce SWK to 2% of the portfolio.

Increase COST to 4.5% of the portfolio.

Have a great week.

Lance Roberts, CIO, RIA Advisors

Lance Roberts

Katy, Texas, United States 15K followers 500+ connections

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