Summary of our views is as follows:
. The price of money is a significant driver of asset prices and economic activity. This has been the largest, fastest increase in rates ever in the US. We believe the full impacts are not yet known.
. While inflation is clearly declining, we doubt it will return to the very low levels targeted by the Federal Reserve anytime soon. The inputs that kept inflation so low for so long (cheap labor; cheap goods; cheap energy as an input to manufacturing) have all changed.
. We caution using a lens from the 2000 – 2021 period as a mechanism to evaluate investments today. A significantly higher price of money, the desire to shrink the Federal balance sheet, and a US Central Bank bias to not cut rates until inflation returns to target are all reasons why the current investing landscape may be quite different than the past.
. From 1968‐82 the equity market experienced multiple violent rallies and subsequent selloffs, and 70% of purchasing power was lost to inflation. We could see a mini period that is similar ‐> choppy markets with multiple large rallies and declines and steady erosion of purchasing power. The risk of a credit crunch in the second half of 2023 remains. Investors are no longer willing to accept zero interest from bank deposits and have been reallocating capital into money market funds or other short duration investments. Regional banks have historically been a major provider of CRE, C&I and personal loans. Regional bank business uncertainty could result in tighter lending standards or even an unwillingness to extend credit.
. Demand for downside protection in the US equity markets remains anemic. Put option skew remains low, while market liquidity has been on a general downtrend. Don’t underestimate the potential for either a grind lower or a gap lower in equity indices in the second half of 2023.
Our least favorite time of year, Hurricane season, rachets up in August and the highest potential for storms continues until the end of October. Seasonality in the US equity markets is the same –> negative for the upcoming period.
Despite the recent pullback, the largest cap US equities continue to look fully valued to us. A price/earnings multiple of ~ 20x on the S&P 500 with rates at 5% is also not cheap in our opinion. The significant divergence between large caps and the rest of the market remains in place, which we continue to view as an unhealthy indicator. For example, the ratio between IWM (small cap equity ETF) and SPY (S&P 500 ETF) is still hovering around the covid lows. While we do generally agree with the premise that AI related productivity will most likely benefit larger companies over smaller ones, we also believe the extreme performance of the mega caps in 2023 has gone too far.
Many of our technical indicators are short term bearish. McClellan Summation indices, moving average crossovers that we favor, and even our proprietary market conditions model are all flashing red. Multiple option market mavens have highlighted that aggregate gamma is negative which implies a more fragile market as hedging flows from the dealing community have the potential to augment directional moves – selling into selloffs and buying into rallies. None of these metrics are predictive, they simply help identify current conditions.
Beyond the technicals which can change rapidly, we continue to be cautious investors in the current environment for the many reasons listed in the first section above. Whether the US enters into a formal recession or not is of little focus to us. We are more focused on the continued path of inflation gauges, as the slower it returns to target, the higher the risk that a risk off event in markets becomes a cascade lower in prices, as we don’t see the Fed willing to cut rates in an elevated inflation environment.
Getting inflation gauges to a point where the Fed is comfortable that their objective has been achieved could take longer than current market expectations. We anticipate headline inflation readings to inch higher into the end of year, driven by base effects and oil prices moving higher. For example, a recent Wells Fargo study showed that oil prices need to remain around 70 bbl for inflation to not tick higher. It appears that core goods inflation is coming down nicely, and we expect that to continue with the manufacturing sector weakness. Services inflation is more troublesome, and continued tight labor markets, along with a US consumer that seems to continue to spend aggressively on experiences isn’t helping.
In summary, we remain cautious, and our asset allocation and positioning reflects this view.
Monthly Podcast Recommendation:
RCM Alternatives: Trend Following Plus Nothing
Jerry Parker discusses his new trend following ETF, ticker TFPN, which stands for “Trend Following Plus Nothing.” Jerry’s classical trend following framework is one we very much agree with, and we wish him much success.
As a reminder, our Sundial Dynamic All‐Weather Portfolios attempt to achieve positive returns regardless of the,macroeconomic regime, such as positive or negative growth, or an inflationary or deflationary environment.
This is achieved through a few key principles:
. Utilize multiple asset classes and strategies, beyond traditional equity and fixed income markets
. Utilize both active (tactical) and passive (buy and hold) strategies
. Recognize that some investments are stability seeking (short volatility bias) and others are instability or dislocation seeking (long volatility bias) and it is critical that a portfolio contains both.
The desired result is a portfolio of non‐correlated revenue streams, that exhibits attractive asymmetry through tactical allocations and return stacking, truncates the downside in adverse markets, and is fully offensive in constructive markets.
Tactical Equity Strategies:
Allocation: High end of the target range
Comment: Our tactical equity strategies have continued to increase exposure over the summer and are generally at their highest levels of investedness of the past 2 years. More importantly, the strategies that are trend / momentum focused have started to see better follow through on positions added. This is a nice despite from the “ breakout ‐> shakeout ” type of behavior that dominated 2022. We remain steadfast in our belief that this is an environment for individual stock picking, and not simply investing in equity indices.
Passive Equity Strategies:
Allocation: Low end of the target range
Comment: Our passive equity longs remain at the low end of our targeted range. These positions are mostly in ETFs and other diversified exposures. We see little reason to tinker with the positions until the macro and central bank outlook is more clear. While we don’t invest based on seasonals, we do respect the weak period that is beginning, and we intend to use any significant weakness to add to existing positions. We are longer term bulls on US equities, however near term we think the indices, and the large caps in particular have run too far.
Yield Generating Strategies:
Allocation: High end of the target range.
Comment: A full allocation reflects both our defensive stance and the attractive opportunity set. There are so many strategies that can generate a high single digit and even mid double digit annual return with very modest risk. We continue to utilize mostly alternative yield generating investments and our Government and corporate bond exposures are limited to short maturities where yields of around 5% are quite attractive. We have been selectively adding to private credit type opportunities that we believe have very low risk of impairment. We are also seeing more preferred equity type of offerings based off of Commercial Real Estate collateral, in property types that we believe still have a positive outlook, such as multi‐family.
Trend Following and Inflation Benefitting Strategies:
Allocation: High end of the target range
Comment: This year has generally been a “nothing burger” for classical trend following strategies that trade multiple markets from either a long or short bias. Despite the lack of any performance, we continue to believe the uncertain macro environment continues to be constructive for “dislocation seeking” trend following strategies. Now more than ever, we embrace this uncorrelated stream of returns, particularly as these strategies could capture some very painful trends of lower stocks, higher or lower rates, and increased implied and realized volatility if we do go into a recession and/or a sustained credit crunch.
Long Volatility / Long Convexity Strategies:
Allocation: High end of the range
Comment: We continue to maintain maximum exposure to these strategies, and when we take on a new portfolio, this is also one of the first positions we initiate. The cost of tail protection (skew) remains extremely low, the potential for a left fat tail is elevated in our opinion, and we are strong proponents of this exposure in all portfolios. Despite the lack of any tail event in 2023, our tail managers have had very limited drawdowns, and the tail strategy manager that is our largest allocation in portfolios is actually slightly positive year to date.
CHARTS & TABLES:
Lots of mentions of QQQ (blue) vs TLT (red) divergence over the past month
Equal Weighted S&P 500: A sideways market for more than 18 months
SPY Daily Heikin Ashi Graph
The SDEX Index is calculated by comparing the implied volatility of a 30‐day at‐the‐money put option to the implied volatility of a 30‐day out‐of‐the‐money put option that is one standard deviation below the at‐themoney strike price. It’s a measure of put skew and/or hedging demand, and this all‐time low suggests long put demand has cratered.
The other index that’s catching a lot of attention is correlation, which is now at lows going back to Q4 of 2017. As a refresher, this index measures the expected 1‐month correlation between the SPX Index and its top 50 single stock components. If asset managers were looking for a crash, they'd be buying downside SPX hedges, which would spike the correlation index.
These metrics all tie back to a lack of demand for downside hedges and/or long volatility. At some point we're likely to see these metrics mean revert, and when they do, it could lead to a rather sharp, episodic increase in volatility.
S&P 500 Call Option Volumes
Partially Driven by Zero Day to Expiry Options:
Lots of interest income generation = money available to be spent by companies and consumers
New listings of homes are down 21% year‐over‐year. Home owners are less likely to want to sell due to how high mortgage rates are.
The 30‐year mortgage rate is at the highest level in 23 years
Mortgage applications are falling close to levels not seen since the Great Financial Crisis
Job losses are increasing on a yearly basis. Past instances have preceded recessions: 2001; 2007; 2020.
Jobless Claims Appear to be Turning Higher – A Canary in the Coal Mine?
Oil is heading higher – and leads CPI.
Core Inflation Components:
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