September Sell-off and Tactical Strategy

Like many others investors, our portfolio bounced back aggressively from the March lows. In early August, market internals enticed me to take profits on many positions and hedge the remaining portfolio.

We did not participate in the August rally, but we are not participating in the

September sell-off.

At some point we are going to have to unwind our hedges and increase our long exposure. On the daily S&P 500 chart somewhere between 3000 and 3100 seems accurate. The 200-day moving average hovers near 3100, the 38.2% Fibonacci retracement is near 3050, and 3000 is a key psychological number.

One would like to see this level on the SPX coincide with the point and figure percentage of companies in bullish formation below 30%, the percent of companies above their 50-day moving average below 20%, and the percent of companies above their 200-day moving average below 45%.

On the weekly chart, it is somewhat encouraging that the SPX tested and held the 20-week moving average, although I suspect that will not last. The next logical move upon a breach of the 20-week is the 50-week moving average that dovetails nicely into our range of 3000 to 3100.

The 14-week RSI continues to hold above 50 and the MACD is about show a bearish cross from elevated levels, which confirms my belief that there is further downside.

This would represent further downside risk of 5% to 8% from these levels.

The elevated VIX level shows continued unease in the US equity markets. While the September swoon has seemed violent, there hasn’t been wide spread panic. Upon the bottoming of this sell-off, one would like to have backwardation between the VIX spot and futures and a 5-day rate-of-change of the VIX greater than 50%.

It would be encouraging to have the put/call ratio rise to between 1.2 to 1.3.

The VIX Skewness Index peak hit 147 in August and has started falling. An anticipated market bottom should coincide with a reading near 115.

I would guess that a failure to pass a stimulus bill in Congress and a messy and contested election will fuel further downside in the market.

I received a notice from Interactive Brokers that they are increasing margin requirements. They note, “elevated option implied volatilities indicate that the markets will be confronting elevated volatility both before and after the November 2020 election. IBKR shares that sentiment and believe it’s appropriate to start controlling leverage in a measured fashion in advance.”

The breakout of the US Dollar also spells new trouble for the US equity markets.

Cuts in GDP estimates This week we saw Goldman Sachs economists cut their fourth-quarter GDP estimate to 3% from 6%, Bank of America lowered its estimate to 3% from 5%, and JP Morgan lowered its fourth-quarter 2020 estimate to 2.5% from 3.5%. The moves come as another round of fiscal stimulus seems unlikely. A surprise stimulus bill pre-election could be a catalyst for the market.

The economic impact from COVID-19 is clearly not over. I found this chart on Yelp that shows many of the temporary closures of small businesses are becoming permanent.

Insiders are not Buying stocks

This article from Bloomberg shows that insiders are not comfortable enough to buy shares in their companies. They note, “A group of investors who correctly timed the stock market’s bottom in March isn’t bargain hunting yet during the current selloff. Instead, they’re stepping up sales, flashing an ominous signal to any dip buyers.

Corporate executives and officers at S&P 500 companies were busy unloading shares of their own firms over the last four weeks. The selling picked up so much versus buying that a measure of insider velocity tracked by Sundial Capital Research pointed to the fastest exit from stocks since 2012.”

Tactical Strategy

I was always of the belief that the market would suffer a one-two punch. The initial sell-off was more in relation to the direct panic from the spread of COVID-19. That happened and we have rebounded incredibly. The next bout of weakness will come from deteriorating economic and earnings. That said, the market is a forward-looking mechanism so the second sell-off will not be as bad as the one we suffered earlier in the year, in my opinion.

I am keeping the portfolio hedged and will start to unwind if we reach 3100 to 3000 in the SPX. I will also consider removing the hedge if the SPX retakes its 50-day moving average on strong volume and stays there for a week or so.

Joseph S. Kalinowski, CFA