Video Transcript
Hello everyone and welcome to beat the market. In the next ten minutes or so I'm going to talk about our investment strategy for the week ahead, with my views on the sectors, and the stocks that will be in our systematic global large cap portfolio.
Last week equities rallied slightly while bonds were little changed.
This puts us in between the growth optimism and liquidity easing regimes. The Dollar strengthened and oil rallied sharply, so that looks like liquidity easing internationally and growth optimism for the US. Overall I'd give the edge to growth optimism, as the rally in oil was the only significant price move.
More concretely, I have a measure of what the equity market is pricing for liquidity.
This measure suggests that equity markets were pricing tighter money last week. However, they are still behind rates markets in this regard, so I think liquidity remains a headwind for equities.
This was the second consecutive week of growth optimism.
I wouldn't exactly call it a pattern as yet since both times it was not convincing. Nevertheless we are coming off an extended period of liquidity easing so
a period of growth optimism is to be expected.
The treasury auctions this week were still quite shaky overall, so from the US perspective I think the trend for higher rates should continue. Equities on the other hand probably need more soft data to continue their uptrend.
The performance of global markets provides more clarity into what actually happened last week.
The Taiwanese Dollar was the strongest currency among nations whose stock market rallied. This tells us that the growth optimism is coming from the AI trade. The US is another beneficiary of that trade, which is part of why the Dollar did relatively well.
Chinese equities were the top performers, but their currency was the weakest. This means that the liquidity easing was taking place in China. Indeed China informed the market of a 0.5% cut to the reserve ratio requirement this week. This ratio, which is typically referred to as the RRR is the percentage of deposits that must be kept as reserves at the central bank. A cut of 0.5% might seem small, but the point is that this frees up capital for the banks to make loans with. The amount of new loans may therefore be something like 10 times the amount of capital made available.
Most developed countries actually don't have a significant reserve requirement, and instead restrain bank risk using capital requirements. The point is that if a bank such as Lehman is making loans worth 20 times their available capital, then even with a 20% reserve ratio requirement they would would have loans of 16 times total capital. This is much higher than a bank that issues loans of 10 times capital and has no reserve requirement.
Among the stocks held by the China ETF FXI, financial stocks were among the main beneficiaries of the move, but consumer stocks were little changed.
Mechanically the change is making banks more profitable, but the market is skeptical that this will translate to an increase in consumption. Energy stocks of course led the way with the big rally in oil.
It was a similar story in the US sectors with energy and financials towards the top, and consumer discretionary at the bottom.
For the second consecutive week, the defensive sectors were also laggards, consistent with growth optimism. Another factor in play here may be the low level of VIX. Traders might think that they can ride the AI rally and then buy protection at a low cost if they feel the need.
Last week I thought that higher rates would cause XLY to move sharply lower to complete 5 waves down. This has now happened, although TSLA was the bigger story than rates. XLY can bounce from here, but the medium term trend is lower, so this would be a bounce to sell. Against XLY I was looking for a rally from trend line support in XLP. Staples did better than the other defensive sectors, and that
rally still looks on, so I'll stick with XLP.
Against XLP this week I like selling financials. XLF was probably helped by the action in China last week, and I'm not ready to get on board with China optimism just yet. It seems like they are just doing more of the same stuff that hasn't worked.
At the industry level last week I thought that home builders and airlines would do poorly.
I was correct about the home builders which joined Uranium and Lithium as the only industry ETFs with meaningful declines. However airlines were the top performing industry ouside of oil.
I think homebuilders are likely to fare even worse this week as more profit taking snowballs into volatility.
For airlines, a lot is going to depend on what happens to oil. The disruption of shipping in the Red Sea is giving airlines a tailwind with cargo, but the rally in airlines this week was also due to a bullish forecast for 2024 travel by American. This means that as yet, oil hasn't risen sufficiently to impact travel demand.
Oil is at something of an inflection point. Either we've just reached the end of a corrective rally, or buying will commence and a large rally that hits airlines will transpire. Open interest in futures has increased for each of the past 3 weeks, so I think the professionals are betting on a rally.
I suspect the reason for this is that US oil production has stopped increasing. The result is that the discount of WTI to Brent has stabilized.
The Biden administration may have gained the support of the oil industry to maximise short term production, but this now appears to be tapped out. Companies are probably still reluctant to invest long term, and so control of oil prices is now back in the hands of OPEC. My bias therefore is for higher oil, but this is not a strong conviction.
Within the oil industry itself, last week I made a technical case for SLB to outperform XOM. As it turned out both just rallied in line with oil, so there doesn't appear to be a relative value trade there.
For the VIX last week it was relatively quiet.
I see some evidence of demand for puts on the Nasdaq, which is consistent with what looks like extremely crowded positioning. This suggests that while some consolidation is likely, people don't want to sell. Next week all the heavy hitters in Tech report earnings, so it's not surprising that the price of short dated puts on Nasdaq went up a bit.
The MOVE index fell quite sharply however. This appears to be traders betting that we won't see a big rally in bonds by selling some calls.
As with last week, I think this is supportive of our higher rates view.
Next let's talk about our systematic global large cap portfolio.
Last week our signal was to move to cash, and this was not too costly. In fact, we were able to lock in a 1.2% gain for the week thanks to some favourable opening levels on Monday. This was just about able to match the return of our benchmark which was 1.3%. We're now up 4.9% on the year compared to 3.3% for the benchmark, which is the MSCI World Large Cap index. Given the rally in the benchmark you might think that we'd have been better to keep our position, but as it turned out, our particular stocks actually closed the week below where they opened.
This was mostly the fault of TSLA of course, which is why I was determined to sell last week. A positive earnings surprise from URI and ABNB outperforming with JETS cancelled this out.
This week our signal is to remain in cash.
Given that our benchmark is long equities, this means that we are effectively short. In some weeks, we may wish not to be short, but also wish not to adopt a high beta portfolio and so just hug the benchmark. There isn't actually an ETF that tracks our benchmark exactly, but ACWI is going to be close enough. A lot of the time
we're going to be running a portfolio with a much higher tracking error, so using ACWI isn't going make a significant difference to this measure overall.
I'd be surprised if big tech earnings are a catalyst for a sell-off next week. Based on positioning and the fact that people might want to take some profit before month-end, I think that semi-conductors are much more likely to have a down week.
The other trade that stands out to me for next week is to sell gold.
Gold has been trading in a contracting range for a while now. As I see it China is not buying above 2,000 and the market is starting to realize that. Positioning still looks crowded, and the volatility skew, which is generally a good signal for gold, is
pointing lower.
Okay so to summarize, we're staying to cash in our systematic global large cap portfolio this week. In the sectors I like selling XLF to fund XLP. I think home builders are going lower and I like selling gold.